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Morningstar 10-K 2008

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

 


 

FORM 10-K

 


 

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007

 

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from            to

 

Commission File Number: 000-51280

 


 

MORNINGSTAR, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Illinois

 

36-3297908

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification Number)

 

225 West Wacker Drive
Chicago, Illinois
60606-6303

(Address of Principal Executive Offices)

 

(312) 696-6000

(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common stock, no par value

 

The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act:  None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o

 

Accelerated filer  x

 

Non-accelerated filer  o

 

Smaller reporting company  o

 

 

 

(Do not check if a smaller reporting company)

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý

 

The aggregate market value of shares of common stock held by non-affiliates of the Registrant as of June 30, 2007 was $613,838,993.

As of February 29, 2008, there were 45,375,260 shares of the Registrant’s common stock, no par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain parts of the Registrant’s Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 



 

TABLE OF CONTENTS

 

 

PART I

 

 

 

Item 1.

Business

Item 1A.

Risk Factors

Item 1B.

Unresolved Staff Comments

Item 2.

Properties

Item 3.

Legal Proceedings

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

PART II

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

Item 6.

Selected Financial Data

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

Item 8.

Financial Statements and Supplementary Data

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Item 9A.

Controls and Procedures

Item 9B.

Other Information

 

 

PART III

 

 

 

Item 10.

Directors, Executive Officers, and Corporate Governance

Item 11.

Executive Compensation

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Item 13.

Certain Relationships and Related Transactions, and Director Independence

Item 14.

Principal Accountant Fees and Services

 

 

PART IV

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

 

 

1



 

Part I

 

Item 1. Business

 

Morningstar is a leading provider of independent investment research to investors around the world. Since our founding in 1984, our mission has been to create great products that help investors reach their financial goals. We offer an extensive line of Internet, software, and print-based products for individual investors, financial advisors, and institutional clients. Our company also provides asset management services for advisors, institutions, and retirement plan participants. In addition to our U.S.-based products and services, we offer local versions of our products designed for investors in Asia, Australia, Canada, Europe, and Japan. Morningstar serves approximately 6.1 million individual investors, 240,000 financial advisors, and 2,400 institutional clients. We have operations in 18 countries and hold minority ownership positions in companies located in three other countries.

 

We maintain a series of comprehensive databases on 10 key types of investments, most of which are widely used by investors globally. After building these databases, we add additional value and insight to the data by investing in our core skills of research, technology, and design. As of December 31, 2007, we provided extensive data on more than:

 

·                  21,000 mutual fund share classes in the United States;

·                  89,000 mutual funds and similar vehicles in international markets;

·                  12,000 stocks;

·                  7,700 hedge funds;

·                  7,300 separate accounts and collective investment trusts;

·                  92,000 variable annuity/life subaccounts and policies;

·                  24,000 insurance, pension, life funds;

·                  1,400 exchange-traded funds;

·                  2,300 closed-end funds;

·                  80 state-sponsored college savings plans (commonly known as Section 529 College Savings Plans); and

·                  80 years of capital markets data capturing performance of 19 market indexes.

 

Our business model is based on leveraging our investments in these databases by selling a wide variety of products in multiple media to three key market segments around the world.

 

Our data and proprietary analytical tools such as the Morningstar Rating for mutual funds, which rates past performance based on risk- and cost-adjusted returns, and the Morningstar Style Box, which provides a visual summary of a mutual fund’s underlying investment style, have become important tools that millions of investors and advisors use in making investment decisions. We’ve created other tools, such as the Ownership Zones, Sector Deltas, and Market Barometer, which allow investors to see how different investments work together to form a portfolio and to track its progress. We developed a Portfolio X-Ray tool that helps investors reduce risk and understand the key characteristics of their portfolios based on nine different factors.

 

In 2007, we completed a major initiative to develop data without survivorship bias. We’re now including “dead” funds (those that have merged or liquidated) in our category averages and percentile ranks to give investors a more accurate representation of fund performance. We’ve also enhanced our research to better reflect derivatives and short positions. Our portfolio statistics now reflect how these financial instruments and trading strategies affect a fund’s asset allocation and risk profile. In addition, we enhanced the methodology for our mutual fund Stewardship Grades.

 

Over the past several years, we’ve expanded our research efforts on individual stocks and have worked to popularize the concepts of economic moat, a measure of competitive advantage originally developed by Warren Buffett, and margin of safety, which reflects the size of the discount in a stock’s price relative to its estimated value. The Morningstar Rating for stocks is based on the stock’s current price relative to our analyst-generated fair value estimates, as well as the company’s level of business risk and economic moat. We offer a variety of qualitative measures such as Stewardship Grades, which help investors identify companies and funds that have demonstrated a high level of commitment to shareholders and stewardship of investors’ capital.

 

We’ve also developed in-depth advice on security selection and portfolio building to meet the needs of investors looking for integrated portfolio solutions. We believe many investors rely on these tools because they offer a useful framework for comparing potential investments and making decisions. Our independence and our history of innovation make us a trusted resource for investors.

 

 

2



 

The Morningstar Rating

 

 

 

 

 

 

We provide Morningstar Ratings on mutual funds, stocks, separate accounts, exchange-traded funds, hedge funds, and closed-end funds, as well as variable annuity/life portfolios and subaccounts. For managed investment products, the Morningstar Rating brings performance and risk together into one evaluation, with the top 10% of rated offerings receiving 5 stars and the bottom 10% receiving 1 star. The Morningstar Rating for stocks is based on the difference between a stock’s current market price and our analyst-generated fair value estimate. It also incorporates our assessment of the company’s level of business risk and economic moat, or competitive advantage.

 

 

The Morningstar Style Box

 

 

 

 

 

 

 

We provide three levels of detail for the Morningstar Style Box: a basic grid illustrating the overall style of a stock or fund, a basic Ownership Zone illustrating the area of the Style Box in which most of the fund’s holdings tend to fall, and a detailed Ownership Zone that plots precisely where the fund’s holdings fall within the Style Box. For the hypothetical mutual fund shown here, the first illustration shows that the funds overall style emphasizes large-capitalization stocks with a blend of value and growth characteristics.

 

The second illustration shows that most of the fund’s investments fall into the large-capitalization range and that the fund puts slightly more emphasis on growth stocks than value-oriented stocks.

 

The third illustration shows the complete distribution of the fund’s holdings. Because some individual holdings have extremely large market capitalizations, they land outside the traditional Style Box range.

 

3



 

Growth Strategies

 

Our mission is to create great products that help investors reach their financial goals. In keeping with our mission, we are pursuing four key growth strategies, which we describe below. We review our growth strategies on a regular basis and refine them as we monitor changes in the business.

 

1.             Enhance our position in each of our three operating segments by focusing on our three major Internet-based platforms.

 

We operate our business in three segments: Individual, Advisor, and Institutional.  We believe that individual investors, financial advisors, and institutional clients increasingly want integrated solutions as opposed to using different research tools for different parts of their portfolios. To help meet the market need for integrated solutions, one of our key strategies is to focus our product offerings on our three major platforms:

 

·  Morningstar.com for individual investors;

·  Morningstar Advisor Workstation for financial advisors; and

·  Morningstar Direct for institutional investment research professionals.

 

These products all include integrated research and portfolio tools, allowing investors to use our proprietary information and analysis across multiple security types. We believe we can achieve deeper penetration of our current audiences with each of these platforms, as well as extend their reach to new customers. With Morningstar.com, we’re focusing on expanding beyond our core audience of mutual fund investors by attracting more stock investors and continuing to expand our reach with our core audience of experienced and engaged investors. We plan to continue intensifying and improving the Morningstar.com customer experience by upgrading the site’s content, speed, and relevance to all users. With Advisor Workstation, we plan to build on our large installed base by continuing to add functionality, such as portfolio accounting, client management, and retirement income tools, which will help us reach more advisors around the world. With Morningstar Direct, we plan to continue an aggressive development program to provide data and analysis on securities and investments around the world. We’re focusing on expanding functionality, selling more licenses to existing clients, and reaching new clients.

 

2.             Become a global leader in funds-of-funds investment management.

 

The large number of managed investment products available has made assembling them into well-constructed portfolios a difficult task for many investors. Consequently, funds-of-funds offerings have seen strong growth within the mutual fund, variable annuity, and hedge fund industries. Cerulli Associates estimates that global multimanager assets—including publicly offered funds that invest in other funds as well as investment vehicles managed by multiple subadvisors—totaled more than $1.9 trillion as of December 31, 2007. We believe assembling and evaluating funds of funds is a natural extension of our expertise in understanding managed investment products.

 

Our investment management programs combine managed investment vehicles—typically mutual funds—in portfolios designed to help investors meet their financial goals. When we create portfolios made up of other funds, our goal is to simplify the investment process and help investors access portfolios that match their level of risk tolerance, time horizon, and long-term investment objectives. We draw on our extensive experience analyzing funds to combine quantitative research with a qualitative assessment of manager skill and investment style.

 

Morningstar Managed Portfolios is a fee-based discretionary asset management service that includes a series of mutual fund, exchange-traded fund, and stock portfolios tailored to meet specific investment time horizons and risk levels. Through our Retirement Advice platform, which includes Morningstar Retirement Manager and Advice by Ibbotson, we also offer managed account services. We offer these managed accounts for retirement plan participants who choose to delegate management of their portfolios to our managed account programs, which select investment options and make retirement planning choices for the participants. We believe that retirement plan participants will continue to adopt managed accounts because of the complexity involved in retirement planning. In addition, the Pension Protection Act of 2006 may encourage plan sponsors to adopt managed accounts as a default investment option.

 

 

4



 

In addition to the assets we manage directly, we had a total of $97.5 billion in assets under advisement in our Investment Consulting business as of December 31, 2007. We significantly expanded our assets under advisement in 2007, with the majority of the growth driven by new asset flows to existing client portfolios, both from Ibbotson Associates and Morningstar Associates. Our consulting business focuses on relationships and agreements where we act as a portfolio construction manager or asset allocation program designer for a mutual fund or variable annuity and receive a basis-point fee. We see continued potential to develop this part of our business, including in markets outside the United States. We plan to continue building this business by focusing on performance and client support, building new relationships, and developing new portfolio strategies and products.

 

3.             Expand the range of services we offer investors, financial advisors, and institutional clients.

 

We plan to expand our product offerings to better meet the needs of investors. We plan to continue building new databases for additional types of investments, including various types of funds outside the United States and other widely used investment products. We expect to expand our product offerings in five primary areas:

 

·                  Enhance our expertise in 10 key investment databases and look for opportunities to develop new databases. We currently provide extensive data on mutual funds, stocks, hedge funds, separate accounts, variable annuities, pension and life funds, exchange-traded funds, closed-end funds, 529 plans, and capital markets. Our data is the foundation for all of the products and services we offer. When we build investment databases, we intend to own the data whenever possible and minimize license agreements with outside data providers. We also focus on proprietary, value-added data, such as our comprehensive data on current and historical portfolio holdings for mutual funds and variable annuities. Within each database, we continuously update our data to maintain timeliness and expand the depth and breadth of coverage. We expect to continue building out additional databases, focusing on investment products that are widely used by large numbers of investors. We also plan to continue our efforts to establish our databases as the pre-eminent choice for individual investors, financial advisors, and institutional clients in markets around the world.

 

·                  Expand and leverage our capabilities in stocks. Our equity research complements our approach to mutual fund analysis, where we focus on analyzing the individual stocks that make up each fund’s portfolio. As of December 31, 2007, we provided analyst research on more than 2,100 companies, plus an additional 250 companies listed in Australia. We’ve focused on building both depth and breadth of coverage by adding additional coverage on initial public offerings and other areas.

 

                        We currently provide research to six major investment banks under the terms of the Global Analyst Research Settlement, which covers the five-year period ending in July 2009. We’re working to sell and distribute our equity research through a variety of other channels, including through financial advisors, buy-side firms, and companies outside of the United States. We believe that investors’ increasing awareness of the value of independent research will strengthen our business over the long term.

 

                        We’ve also expanded our proprietary stock database, which we view as an important complement to our analyst research. We currently have data coverage on approximately 12,000 companies based in the United States, Canada, and Australia. Following our acquisition of the Hemscott businesses (described in more detail below), we expect to expand the number of companies covered in the United Kingdom, Ireland, and Europe, as well as add more data history and management and director information on many of the companies already in our database. We expect that our combined equity database will include comprehensive data coverage on approximately 20,000 companies after integrating Hemscott’s data.

 

 

5



 

·                  Expand our capabilities in hedge fund research. We plan to expand our research and data on hedge funds with the goal of making the hedge fund industry more transparent to investors. Hedge funds worldwide held more than $1.9 trillion in investor assets as of December 31, 2007, based on data from Hedge Fund Research, Inc. Offering data on hedge funds is a natural extension of our work on other managed investment vehicles. We now provide comprehensive data on about 7,700 hedge funds.

 

·                  Continue developing retirement income capabilities. As the baby boom generation approaches retirement, we believe many investors will need more information to help them manage income during retirement. We believe these trends will lead to a greater need for information and tools focusing on retirement income planning and long-term savings strategies. We currently offer Retirement Income Strategist, a Web-based financial planning tool that allows financial advisors to create comprehensive income analyses for clients who are in or approaching retirement, as part of our Advisor Workstation platform. We’ve developed several retirement income services for institutional clients within our Investment Consulting area, and we plan to incorporate additional retirement income tools and services in other products over the next several years.

 

·                  Continue expanding our index business. Over the past several years, we’ve developed a series of proprietary investment indexes. The Morningstar Indexes are rooted in our proprietary research, with each index vetted for appropriateness and investment value. They can be used for precise asset allocation and benchmarking and as tools for portfolio construction and market analysis. All of our indexes are based on transparent, rules-based methodologies that are back-tested and supported by original research papers.  Each is backed by rigorous research to help investors understand, invest in, and monitor the capital markets. Consistent methodology and objective rules make the indexes well-suited for creating index-linked investment products, such as exchange-traded funds, mutual funds, and structured products. We plan to increase the number of indexes we offer, including in markets outside of the United States.

 

4.             Expand our international brand presence, products, and services.

 

Over the past several years, we have expanded our product offerings outside the United States. Our recent acquisitions of several Hemscott businesses, the mutual fund data business from Standard & Poor’s, and Aspect Huntley (described in more detail below) all significantly expanded our operations outside of the United States. Our operations outside of the United States generated $89.7 million in revenue in 2007, including $31.7 million from acquisitions, compared with $44.3 million in 2006. We plan to continue expanding our non-U.S. operations to meet the increasing demand for wide-ranging, independent investment insight by investors around the globe. Because more than half of the world’s investable assets are located outside of the United States, we believe there are significant opportunities for us in non-U.S. markets. Our strategy is to focus our non-U.S. sales efforts on our major products, including Morningstar Advisor Workstation and Morningstar Direct. We also plan to increase our sales staff, build a larger analyst team outside the United States, and explore new markets, such as India, Latin America, and South Africa.

 

Acquisitions

 

The majority of our revenue has been driven by organic growth as we’ve introduced new products and services and expanded our marketing efforts for existing products. However, we have made and expect to continue making selective acquisitions that support our four key growth strategies. In reviewing potential acquisitions, we plan to focus on transactions that:

 

·                  offer a good strategic fit with our mission of creating great products that help investors reach their financial goals;

·                  help us build our proprietary investment databases, research capabilities, technical expertise, or customer base faster and more cost effectively than we could if we built them ourselves; and

·                  offer a good cultural fit with our entrepreneurial spirit and brand leadership.

 

 

6



 

Hemscott data, media, and investor relations Web site businesses

 

In January 2008, we acquired the Hemscott data, media, and investor relations Web site businesses from Ipreo Holdings LLC. This acquisition fits our strategies of building a premier global equity database and expanding our presence outside the United States. The acquisition significantly strengthens our equity coverage and adds decades of additional data history to our existing stock data coverage, as well as management and director information for United States, United Kingdom, and Canadian companies. As part of the transaction we also acquired a sizable data operation in India, a leading investor Web site in the United Kingdom, and a UK-based investor relations Web site business that leverages our data and analytics for investor relations professionals. We paid $51.6 million in cash for the acquisition, subject to working capital adjustments.

 

Mutual fund data business acquired from Standard & Poor’s

 

In March 2007, we acquired the mutual fund data business from Standard & Poor’s for $57.8 million in cash including post-closing adjustments and transaction costs directly related to the acquisition, less cash acquired. The mutual fund data business consists of data and products covering approximately 135,000 managed investment vehicles, including mutual funds, ETFs, hedge funds, and offshore funds. Approximately 80% of the mutual fund data business acquired from Standard & Poor’s is outside the United States.

 

We have also made other acquisitions over the past several years. For more information, refer to Note 7 of the Notes to our Consolidated Financial Statements.

 

Business Segments, Products, and Services

 

We divide our business operations into three segments:

 

·                  Individual, which focuses on products and services for individual investors;

 

·                  Advisor, which focuses on products and services for financial advisors; and

 

·                  Institutional, which focuses on products and services for institutional clients, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors.

 

The table below shows our revenue by business segment for each of the past three years:

 

 

 

2007

 

2006

 

2005

 

Revenue by Segment ($000)

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Individual

 

 

$

97,299

 

 

22.4%

 

 

$

80,706

 

 

25.6%

 

 

$

63,448

 

 

27.9%

 

Advisor

 

 

115,739

 

 

26.6

 

 

94,694

 

 

30.0

 

 

72,689

 

 

32.0

 

Institutional

 

 

230,329

 

 

52.9

 

 

146,085

 

 

46.4

 

 

95,947

 

 

42.2

 

Elimination of intersegment revenue

 

 

(8,260

)

 

 (1.9)

 

 

(6,310

)

 

 (2.0)

 

 

(4,970

)

 

   (2.1)

 

Consolidated revenue

 

 

$

435,107

 

 

100.0%

 

 

$

315,175

 

 

100.0%

 

 

$

227,114

 

 

100.0%

 

 

For information on segment operating income (loss), refer to Note 5 of the Notes to our Consolidated Financial Statements.

 

7



 

Individual Segment

 

For individual investors, our largest product based on revenue is our U.S.-based Web site, Morningstar.com, which includes our Premium Membership service and sales of Internet advertising space. Morningstar.com is consistently mentioned in major business publications as one of the best investment sites on the Web. Our Individual business segment also includes Morningstar Equity Research, which we distribute through several channels. Investors can access our equity research through the Premium Membership service on Morningstar.com. Our independent equity research is also distributed through six major investment banks to meet the requirement for independent research under the Global Analyst Research Settlement, which covers the five-year period ending in July 2009. In addition, we distribute our research to several other companies who provide our analyst reports and research to their affiliated financial advisors or to individual investors.

 

We also offer several print and online publications focusing on stocks, mutual funds, personal finance, and other investing topics. We sell several investment newsletters, including Morningstar FundInvestor and Morningstar StockInvestor; and annual reference guides, including the Morningstar Funds 500, the Morningstar Stocks 500, the Morningstar ETFs 150, and the Stocks, Bonds, Bills, and Inflation Yearbook. This segment also includes several newsletters and other publications for investors in Australia. In 2007, about 10% of Individual segment revenue was from outside of the United States.

 

We offer free local Web sites for investors in Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, Korea, the Netherlands, New Zealand, Norway, People’s Republic of China, Spain, Sweden, Switzerland, Taiwan, and the United Kingdom. Our Web sites and publications for individual investors reach approximately 6.1 million investors worldwide.

 

Within the Individual business segment, most of our products target experienced investors who are actively involved in the investing process and want to take charge of their own investment decisions. We also reach individuals who want to learn more about investing and investors who seek out third-party sources to validate the advice they receive from brokers or financial planners. Our client base in this segment consists of more than 280,000 paying customers, including 180,366 Premium members of Morningstar.com and approximately 100,000 subscribers who purchase our investment newsletters designed for individual investors. Following the Hemscott acquisition, we also have an additional 1,800 Premium subscribers for Hemscott.com in the United Kingdom. Approximately 3,800 public and private libraries in the United States subscribe to our services. We also offer a series of books and workbooks about investing, as well as formatted printable reports on individual securities.

 

We promote our individual investor products primarily through traditional direct mail, e-mail, promotions on our 24 investor Web sites worldwide, public relations, and advertising on related Web sites.

 

Our strategy is to increase the number of investors who sign up for Morningstar.com Premium Membership by continuing to develop and promote Premium content such as analyst reports, Fund Analyst Picks and Pans, and value-added portfolio tools, which we market to registered users and other investors. We use search marketing as a core marketing strategy for Morningstar.com. This includes working to optimize our site’s ranking in the search results that appear when users search for information about investing and purchasing advertisements on third-party sites such as Yahoo! and Google that can bring investors to relevant content on Morningstar.com.

 

In the Individual business segment, we compete with the personal finance Web sites of AOL Money & Finance, CNN Money, Google Finance, MarketWatch, MSN Money, The Motley Fool, SmartMoney.com, The Street.com, The Wall Street Journal Online, and Yahoo! Finance. Our print publications compete with Agora Publishing, Forbes, The Motley Fool, Phillips Investment Resources, and Value Line in the United States and Australian Wealth Report, Fat Prophets, Intelligent Investor, and The Rivkin Report in Australia.  Our Equity Research services compete with Standard & Poor’s, Value Line, Zacks Investment Research, and several smaller research firms.

 

We believe the Individual segment has a modest amount of seasonality. The first quarter tends to show more sales activity for Premium Membership on Morningstar.com and our annual reference guides, including the Stocks, Bonds, Bills, and Inflation Yearbook. Sales in the Individual segment tend to be slightly lower over the spring and summer months. However, our diversified product base and recognizing revenue ratably over the term of each subscription moderates the impact of this seasonality.

 

Our largest customer in the Individual segment made up approximately 6% of segment revenue in 2007.

 

8



 

Morningstar.com

 

Our largest Web site for individual investors is Morningstar.com in the United States. As of December 31, 2007, the free membership services offered through Morningstar.com had more than 5.8 million registered users worldwide, who have access to comprehensive data on individual stocks, mutual funds, exchange-traded funds, hedge funds, and other investments to help them conduct research and track performance. In addition, Morningstar.com features extensive market data, Morningstar articles, proprietary portfolio tools, and educational content to help investors of all levels access timely, relevant investment information. Morningstar.com also includes Portfolio X-Ray, which helps investors reduce risk and understand key characteristics of their portfolios, and a variety of other portfolio tools.

 

We use our free content as a gateway into paid Premium Membership, which includes access to written analyst reports on more than 2,100 stocks, 2,000 mutual funds, and 165 exchange-traded funds, as well as Analyst Picks and Pans, Stewardship Grades, and Premium Stock and Fund Screeners. We currently offer Premium Membership services in the United States, China, and the United Kingdom.

 

To help draw investors deeper into Morningstar.com, in 2007 we significantly expanded video content and the number of articles published by our editorial staff. We overhauled the cover pages for the stock and fund areas of the site and improved the conversations area of the site to better highlight user-generated content. We also created an Options Center that includes comprehensive equity option data, education, analysis, and a family of proprietary option volatility indexes.

 

As of December 31, 2007, we had 180,366 paid Premium subscribers for Morningstar.com in the United States plus an additional 2,100 Premium subscribers in China. Following our January 2008 acquisition of the Hemscott businesses, we had 1,800 Premium subscribers to Hemscott.com in the United Kingdom. We currently charge $16.95 for a monthly subscription, $159 for an annual subscription, $269 for a two-year subscription, and $369 for a three-year subscription for Morningstar.com’s Premium service in the United States. We also sell advertising space on Morningstar.com.

 

Morningstar.com is one of our five largest products based on revenue and was our largest product in the Individual segment in 2007. This product accounted for 8.6%, 9.9%, and 11.2% of our consolidated revenue in 2007, 2006, and 2005, respectively.

 

 

 

9



 

Morningstar Equity Research

 

As of December 31, 2007, we offered independent equity research on more than 2,100 companies, plus an additional 250 companies based in Australia. Our approach to stock analysis focuses on long-term fundamentals. Our analysts evaluate companies by assessing each firm’s competitive advantage, analyzing the level of business risk, and completing an in-depth projection of future cash flows. For the companies we cover, our analysts prepare a fair value estimate, a Morningstar Rating for stocks, a rating for business risk, and an assessment of the company’s economic moat. Economic moat is a concept originally developed by Warren Buffett that describes a company’s competitive advantage relative to other companies. For the remaining stocks included in our database, we offer quantitative grades for growth, profitability, and financial health, as well as an explanation of the company’s business operations. We currently deliver our equity research to individual investors as part of our Premium Membership service on Morningstar.com and to six major investment banks under the terms of the Global Analyst Research Settlement, as well as to several other companies who provide our research to their affiliated financial advisors or to individual investors.

 

We have significantly expanded our equity research coverage over the past several years. We currently provide analyst reports on virtually all of the most widely held stocks in the S&P 500 index, as well as numerous companies included in other indexes. We continue to expand our analyst staff to support these research efforts and had 112 stock analysts around the world as of December 31, 2007, compared with 100 as of December 31, 2006.

 

We continue to focus on building our competitive advantage by expanding the breadth and depth of our equity coverage. As part of this effort, in 2007 we increased coverage of initial public offerings, and now cover about 100 pre-IPO and newly public companies.

 

Pricing for Morningstar Equity Research varies based on the level of distribution, the number of securities covered, the amount of custom coverage required, and the length of the contract term. Morningstar Equity Research, which primarily consists of revenue related to the Global Analyst Research Settlement, was the second-largest product in the Individual segment based on revenue in 2007, following Morningstar.com. The period covered by the Global Analyst Research Settlement will expire in July 2009. After the settlement period expires, the investment banks covered by it will no longer be required to provide independent investment research to their clients. For further discussion about this issue, see Item 1A — Risk Factors.

 

Newsletters and Other Publications

 

We offer a variety of print and electronic publications about investing. Some of these include Morningstar Mutual Funds, a reference publication that features our signature one-page reports on approximately 1,600 mutual funds; Morningstar FundInvestor,  a monthly newsletter that provides information and insight on 500 of the most popular mutual funds and a list of 175 Analyst Picks; Morningstar StockInvestor,  a monthly newsletter that focuses on companies with strong competitive positions and stock prices that we believe are low enough to provide investors with a margin of safety; and the Stocks, Bonds, Bills, and Inflation Yearbook, the definitive study of historical capital markets data in the United States. In addition, we offer several other investment newsletters and a series of books about investing in stocks, mutual funds, and exchange-traded funds, which are available directly from us and in bookstores. In early 2008, we published two new investment books, The Ultimate Dividend Playbook and The Little Book that Builds Wealth.

 

Our Individual segment also includes several publications for investors in Australia, including IFA Magazine, Australia’s leading magazine for independent financial advisors; Your Money Weekly, which focuses on the larger companies listed in Australia; and Smaller Companies Guide, a weekly newsletter with investment recommendations and portfolio ideas focusing on smaller-sized stocks.

 

Advisor Segment

 

For financial advisors, our largest products based on revenue are Morningstar Advisor Workstation, a comprehensive Web-based investment planning system, and Principia, our CD-ROM-based investment research and planning software. We also offer Morningstar Managed Portfolios, a fee-based discretionary asset management program distributed exclusively through financial advisors. Our advisor products are integrated into the daily operations and research processes of many financial advisors who use our research and tools to provide guidance for individual investors. According to a report published in January 2005 by the consulting firm Tiburon Strategic Advisors, Morningstar was ranked as the leading provider of investment research and data, financial planning software, and asset allocation software among approximately 1,500 independent financial advisors surveyed.

 

We sell our advisor-related products both directly to independent financial advisors and through enterprise licenses, which allow financial advisors associated with the licensing enterprise to use our products. Most of our license agreements in the Advisor segment have terms ranging from one to three years. As of December 31, 2007, we had established relationships with approximately 240,000 financial advisors around the world. Approximately 16% of our Advisor segment revenue was from international sales in 2007. In addition to the U.S. versions of our Advisor products, we offer products for financial advisors in a variety of other countries. For example, we have versions of Advisor Workstation tailored for use in Asia, Australia, Canada, and Europe, and we offer a product similar to Principia in Canada.

 

 

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Our products for advisors are sold primarily through our sales force, with promotional support from direct mail, online and print advertising, public relations, and conference exhibits. We also use the annual Morningstar Investment Conference to promote our offerings for advisors. We believe that there are opportunities to increase Advisor Workstation sales by attracting additional brokerage firms and investment advisors and increasing revenue per license from existing clients by expanding the amount of functionality licensed. We plan to expand our offerings for financial advisors outside the United States. Our primary competitors in the Advisor segment include Advisor Software, Inc. Advent Software, Interactive Advisory Software, MoneyGuide Pro, Schwab Portfolio Center, Standard & Poor’s, SunGard, and Thomson Financial Services. For Morningstar Managed Portfolios, our primary competitors are AssetMark, Brinker Capital, Curian, Envestnet PMC, FundQuest, Genworth, SEI Investments, and Symmetry.

 

In the Advisor segment, we typically have higher revenue growth in the second quarter because we hold an annual investment conference in June. Other products in this segment generally have not shown marked seasonality.

 

Our largest customer in this segment accounted for approximately 3% of segment revenue in 2007.

 

Morningstar Advisor Workstation

 

Morningstar Advisor Workstation, a Web-based investment planning system, provides financial advisors with a comprehensive set of tools for conducting their core business—including investment research, planning, and presentations. It allows advisors to build and maintain a client portfolio database that can be fully integrated with the firm’s back-office technology and resources. Moreover, it helps advisors create customized reports for client portfolios that combine mutual funds, stocks, separate accounts, variable annuity/life subaccounts, exchange-traded funds, hedge funds, and closed-end funds. As of December 31, 2007, more than 175,000 advisors in the United States were licensed to use Advisor Workstation, which is available in two editions: the Office Edition for independent financial advisors and the Enterprise Edition for financial advisors affiliated with larger firms. Advisor Workstation Enterprise Edition includes a variety of modules, including Retirement Income Strategist, Retirement Income Education Center, Portfolio Builder, Hypothetical Illustrator, and a variety of tools to measure the relative cost and portfolio fit of various types of investments. These modules can be purchased as stand-alone products or combined as part of a full Workstation license. Pricing for the Enterprise Edition varies based on the number of users, as well as the level of functionality offered, and generally ranges between $80 and $2,800 per licensed user. We generally charge $5,000 per user for an annual license for Office Edition.

 

In 2007, we began selling our Global Hypothetical Illustrator and Portfolio Builder tools in several additional countries, including Canada, Hong Kong, India, and various countries in Europe and Latin America. We launched a local version of Advisor Workstation Office Edition in the United Kingdom and added functionality allowing advisors to create investment policy statements. In addition, we incorporated Ibbotson’s wealth forecasting engine and other asset allocation methodologies into Advisor Workstation Enterprise Edition. We also created a new Site Builder module that helps investment advisory firms build Web sites.

 

Morningstar Advisor Workstation is one of our five largest products based on revenue and made up 12.6%, 13.7%, and 12.9% of our consolidated revenue in 2007, 2006, and 2005, respectively.

 

 

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Morningstar Principia

 

Principia is our CD-ROM-based investment research and planning software for financial planners and had 48,900 subscriptions as of December 31, 2007. The modules offered in Principia provide data on mutual funds, stocks, separate accounts, variable annuity/life subaccounts, exchange-traded funds, closed-end funds, defined contribution plans, asset allocation, and presentations and education. Each module is available separately or together in a CD-ROM format and features searching, screening, and ranking tools. Principia allows advisors to create integrated portfolios for clients and offers three-page Portfolio Snapshot reports that provide a comprehensive picture of the client’s portfolio. The Snapshot report shows overall style and sector weightings as well as the cumulative exposure to individual stocks. The Snapshot report is among those approved by the National Association of Securities Dealers for financial advisors to distribute and review with their clients. Principia prices generally range from approximately $675 per year for monthly updates on one investment database to $3,345 per year for monthly updates on the complete package spanning all investment universes, or $5,335 for all investment universes plus additional modules for asset allocation and presentations and education.  Pricing for Principia Enterprise licenses varies based on the investment universes selected, level of functionality, and number of users and generally starts at about $675 per user.

 

In 2007, we added two new modules, Asset allocation and Presentations &Education, to the Principia product line.

 

Principia is one of our five largest products based on revenue and accounted for 6.6%, 9.1%, and 12.7% of our consolidated revenue in 2007, 2006, and 2005, respectively.

 

Morningstar Managed Portfolios

 

Morningstar Managed Portfolios is a fee-based discretionary asset management service that includes a series of mutual fund, exchange-traded fund, and stock portfolios tailored to meet specific investment time horizons and risk levels. This program is only available through financial advisors. Our team of investment professionals uses a disciplined process for asset allocation, fund selection, and portfolio construction. They actively monitor the portfolios and make adjustments as needed. We complement these asset management services with online client-management functions such as risk profiling and access to client statements, transaction capabilities, and performance reports.

 

We had approximately $2.2 billion in assets under management as of December 31, 2007. We charge asset-based fees for Morningstar Managed Portfolios. The management fee is based on a tiered schedule that depends on the client’s average daily portfolio balance and generally ranges from 0.20% to 0.40% of assets.

 

In 2007, we launched Managed Portfolios Select Stock Baskets, a managed account service consisting of individually customized stock portfolios based on Morningstar’s proprietary indexes and independent equity research. The Morningstar Indexes form the basis of each stock basket’s investment composition, and the stock basket is tailored to suit an investor’s specific parameters, including sector and industry exposure, stock restrictions, existing holdings, and personal tax situation. Our investment professionals then select stocks for the portfolio using Morningstar’s extensive data and research on the stocks within the index, giving more weight to higher-rated stocks and less weight to stocks with low Morningstar Ratings.

 

The Morningstar Managed Portfolios program is offered through Morningstar Investment Services, Inc., a registered investment advisor, registered broker-dealer, member of the Financial Industry Regulatory Authority, Inc. (FINRA), and wholly owned subsidiary of Morningstar, Inc.

 

In addition to the products described above, we offer a series of FINRA-reviewed Financial Communications materials that advisors can use to educate clients about asset allocation and demonstrate other key investment concepts. The materials include our SBBI Kit, which is a collection of presentation materials based on Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation research. In addition, we offer free Web sites for advisors and introduced a new magazine, Morningstar Advisor, in 2007.

 

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Institutional Segment

 

For institutional clients, our largest products and services based on revenue include:

 

·                  Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities;

·                  Licensed Data, a set of investment data spanning 10 core databases, available through electronic data feeds;

·                  Retirement Advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms;

·                  Morningstar Direct, a Web-based institutional research platform that provides advanced research and tools on the complete range of securities in Morningstar’s global database;

·                  Morningstar Workstation for institutions (formerly S&P Micropal Workstation), a desktop resource for advanced analysis of fund performance;

·                  Licensed Tools and Content, a set of online tools and editorial content designed for institutions to use in their Web sites and software; and

·                  Morningstar EnCorr, an asset allocation software package.

 

The Institutional segment also includes Investment Profiles & Guides, which are designed for institutions to use in communicating investment information to individual investors; Morningstar Indexes, a growing product line that currently covers U.S. equities (by style, capitalization, sector, and dividend), commodities, bonds, and equity focus index families; and financial information and data feeds on Australian stocks, which we sell to stock brokers, information providers, and financial Web sites.

 

As of December 31, 2007, we served approximately 2,400 clients through our Institutional segment, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan sponsors and providers. We believe our institutional clients value our independence, breadth of information, and customized services; in addition, we believe our research, tools, and advice reach many individual investors through this channel. Across the Institutional segment, we’ve established relationships with many of the largest companies in the financial services industry, including AEGON/Transamerica, Prudential, ING, MetLife, and Fidelity. Approximately 27% of our institutional segment revenue is from outside of the United States—primarily in Australia, Canada, and various countries in Europe. We typically sell our institutional products based on a contract term of one to three years.

 

We market our products for institutions almost exclusively through our sales team. We provide marketing support for our sales team with online and print advertising, public relations, direct mail, and conference exhibits. We also have data reselling agreements with third-party providers of investment tools and applications, allowing us to increase the distribution of our data with minimal additional cost.

 

For Licensed Data and Investment Profiles & Guides, our primary competitors are Bloomberg, FactSet Research Systems, Lipper, Standard & Poor’s, Thomson Financial, Eurekahedge, eVestment Alliance, and Hedge Fund Research, Inc. For Morningstar Direct, our primary competitors are Bloomberg, eVestment Alliance, FactSet Research Systems, Informa, Lipper, Mercer, MPI Stylus, PerTrac, Strategic Insight, Wilshire, and Zephyr Management. Our Investment Consulting business competes primarily with Lipper, Frank Russell, Mercer, and Wilshire, as well as some smaller firms in the retirement consulting business. In the retirement advice market, we compete primarily with Financial Engines, Guided Choice, Mesirow Financial, and ProManage.

 

Most products within our Institutional segment have not shown pronounced seasonality.

 

Our largest customer in the Institutional segment accounted for approximately 9% of segment revenue in 2007.

 

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Investment Consulting

 

Our Investment Consulting area provides a broad range of services, many of which emphasize investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities. We offer Investment Consulting services primarily through Morningstar Associates, LLC and Ibbotson Associates, Inc., which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. In both areas, we emphasize contracts where we’re paid a percentage of assets under management for ongoing investment management and consulting, as opposed to one-time relationships where we’re paid a flat fee.

 

Morningstar Associates generally focuses on a small number of large relationships. We emphasize innovative solutions that improve the investor experience and help our clients build their businesses. We provide customized solutions that help clients differentiate their businesses.

 

Our investment professionals evaluate investment plans, recommend strategies, help set investment policies, develop asset allocation programs, construct portfolios, and monitor ongoing performance. We offer these consulting services to clients in the United States, Asia, Australia, Canada, and Europe, including insurance companies, investment management companies, mutual fund companies, and broker-dealers. We also provide services for retirement plan sponsors and providers, including developing plan lineups, creating investment policy statements, and monitoring investment performance.

 

Our team of investment consultants draws on both quantitative research tools and qualitative expertise to assess investment programs, provide detailed analysis of performance and portfolio characteristics, and make comprehensive recommendations for improvement. We also offer investment manager search services. Our staff combines the depth of Morningstar’s historical fundamental databases with detailed investment knowledge and investment experience to recommend qualified candidates for subadvisory firms, mutual fund managers, variable insurance trust managers, and separate account managers. Our investment monitoring services include analyst reports, customizable board reports, select lists, watch lists, and in-depth attribution analysis.

 

In 2006, we significantly expanded our Investment Consulting area when we acquired Ibbotson Associates, which has a well-established consulting business that began in 1977. Ibbotson’s Investment Consulting unit is a leading authority on asset allocation and draws on its knowledge of capital markets and portfolio building to construct portfolios from the top down, starting at the asset class level. Ibbotson develops customized asset allocation programs for mutual fund firms, banks, broker-dealers, and insurance companies.

 

Ibbotson provides a range of consulting services, including licensing its asset allocation models, providing consulting services, and acting as a portfolio sub-advisor. Ibbotson works with different types of investment options, including mutual funds, variable annuities, and exchange traded funds, and provides both strategic and dynamic asset allocation services. The group offers consulting services and funds-of-funds subadvisory services, as well as tailored model portfolios, fund classification schemes, and questionnaire design.

 

Pricing for the consulting services we provide through both Morningstar Associates and Ibbotson Associates is based on the scope of work and the level of service required. In the majority of our contracts, we receive asset-based fees, reflecting our work as a portfolio construction manager or subadvisor for a mutual fund or variable annuity.

 

In 2007, we expanded the range of investment strategies on which we provide advisory services and continued working to expand our consulting business outside of the United States.

 

Investment Consulting is currently our largest product based on revenue and accounted for 17.4%, 14.8%, and 9.6% of our consolidated revenue in 2007, 2006, and 2005, respectively.

 

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Licensed Data

 

Our Licensed Data service gives institutions access to a set of proprietary investment data spanning 10 core databases. The data packages we offer include proprietary statistics, such as the Morningstar Style Box and Morningstar Rating, and a wide range of other data, including information on investment performance, risk, portfolios, operations data, fees and expenses, cash flows, and ownership. Institutions can use Licensed Data in a variety of investor communications, including Web sites, print publications, and marketing fact sheets, as well as for internal research and product development. We deliver Licensed Data through electronic data feeds and provide daily updates to clients. Pricing for Licensed Data is based on the number of funds or other securities covered, the amount of information provided for each security, and the level of distribution.

 

In 2007, we introduced data feeds containing daily net asset values and added information covering hedge funds, global pricing feeds, and returns-based style analysis.

 

Licensed Data is one of our five largest products based on revenue and accounted for 13.6%, 12.0%, and 14.3% of our consolidated revenue in 2007, 2006, and 2005, respectively.

 

Retirement Advice

 

We offer two Retirement Advice offerings that help retirement plan participants plan and invest for retirement: Morningstar Retirement Manager, a service of Morningstar Associates, LLC, and Advice by Ibbotson, a service of Ibbotson Associates, Inc.  Both companies are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc.

 

Morningstar Retirement Manager is designed to help retirement plan participants determine how much to invest and which investments are most appropriate for their portfolios. It gives clear guidance explaining whether participants’ suggested plans are on target to meet their retirement goals. As part of this service, we deliver personalized recommendations for a target savings goal, a recommended contribution rate to help achieve that goal, a portfolio mix based on risk tolerance, and specific fund recommendations. Morningstar Retirement Manager includes a managed account service designed for plan participants who choose to delegate management of their portfolios to Morningstar’s investment professionals. We offer these services primarily through retirement plan providers—typically third-party asset management companies or companies that offer administrative services to retirement plans. These providers often offer proprietary mutual funds to retirement plan sponsors and their participants. As of December 31, 2007, approximately 8.8 million plan participants had access to Morningstar Retirement Manager through approximately 75,000 plan sponsors and 22 plan providers. Pricing for Morningstar Retirement Manager depends on the number of participants, as well as the level of service we provide.

 

Advice by Ibbotson offers a set of services and proprietary software to give retirement plan participants access to investment education, self-service advice, and managed retirement accounts. We offer these services mainly through retirement plan providers. The platform includes installed software advice solutions that can be co-branded by retirement plan sponsors and providers. Advice by Ibbotson combines asset allocation and patented human capital methodologies that help participants determine how to prepare for retirement based on their financial assets as well as their future earnings and savings power. Advice by Ibbotson’s customized software can be integrated with existing systems to help investors accumulate wealth, transition into retirement, and manage income during retirement. As of December 31, 2007, approximately 6.6 million plan participants had access to Advice by Ibbotson through approximately 60,000 plan sponsors and eight plan providers. Pricing for Advice by Ibbotson depends on the number of participants, as well as the level of service we provide.

 

Morningstar Workstation for institutions (formerly S&P Micropal Workstation)

 

With our acquisition of the mutual fund data business from Standard & Poor’s, Morningstar now offers Morningstar Workstation for institutions (formerly S&P Micropal Workstation), an all-inclusive desktop resource for advanced performance analysis of global funds. It provides a comprehensive toolkit for the calculation, benchmarking, and presentation of performance information. Investment professionals can assess global fund performance and suitability using more than 85 calculation options, 85 currencies, and 15,000 indexes. Users can define their own analysis parameters and incorporate private data into performance calculations. Morningstar Workstation includes both standard and customizable templates for data presentation and allows users to easily integrate tables and charts into documents, spreadsheets, and presentations.

 

Pricing for Morningstar Workstation is based on the number of users and database subscriptions.

 

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Morningstar Direct

 

Morningstar Direct is a Web-based institutional research platform that provides advanced research on the complete range of securities in Morningstar’s global database. This comprehensive research platform allows research and marketing professionals to conduct advanced performance comparisons and in-depth analyses of a portfolio’s underlying investment style. Morningstar Direct includes access to numerous investment universes, including U.S. mutual funds; European and offshore funds; funds based in most major markets around the world; stocks; separate accounts; hedge funds; closed-end funds; exchange-traded funds; global equity ownership data; variable annuity and life portfolios; and market indexes.

 

In 2007, we enhanced Morningstar Direct by incorporating additional data on shorts and derivatives, adding a new alerts feature, enhancing our capabilities in aggregate and custom funds, adding additional charts, and improving the Report Builder functionality. In addition, we increased index coverage to nearly 30,000 global indexes and expanded our coverage in pension and life funds, offshore funds, and other data universes outside the United States. Morningstar Direct had 2,229 licensed users worldwide as of December 31, 2007.

 

Pricing for Morningstar Direct is based on the number of licenses purchased. We charge $15,000 for the first user, $10,000 for the second user, and $7,500 for each additional user.

 

 

Licensed Tools and Content

 

We offer an extensive set of online tools and editorial content that institutional clients can license to use in their Web sites and software products. Clients can select from more than 40 different tools and content offerings or purchase modules focusing on screening and performance tools, editorial commentary and educational articles, or goal planning and portfolio analysis. Our online tools and content can be customized to meet the needs of international audiences, and can also be modified to analyze a set of investments, focus on client-defined data points, or perform calculations required by specific products or services. We also offer licenses for investment research and portfolio analysis tools. Licensed Tools and Content can be integrated with a client’s existing Web site and allows users to drill down into the underlying data when researching a potential investment.

 

Pricing for Licensed Tools and Content depends on the audience, the level of distribution, and the scope of information and functionality licensed.

 

Morningstar EnCorr

 

Morningstar EnCorr is an asset allocation software platform that helps institutional clients create, analyze, and implement asset allocation strategies. This advanced research tool allows investment professionals to develop recommendations and produce portfolios at various risk/reward tradeoffs along the efficient frontier, which is a visual representation of the asset mixes that deliver the highest return per unit of risk. EnCorr incorporates historical data analysis, strategic asset allocation, forecasting, returns-based style analysis, portfolio attribution, and advanced statistical and graphical analyses. Target clients include analysts, investment consultants, registered investment advisors, and portfolio managers.

 

Pricing for EnCorr is based on the number of licenses purchased. We charge $10,000 for the first user and $3,000 for each additional user.

 

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Morningstar Indexes

 

Based on the same methodology as the Morningstar Style Box, our 50 real-time indexes track the U.S. equity market by capitalization, investment style, and other traits. They include a broad market index, three capitalization-based indexes, three composite style indexes, nine indexes based on investment style and market capitalization, 15 sector indexes, two dividend indexes, 14 bond indexes, five commodity indexes, and one focused stock index.  These indexes can also be licensed to institutions for creating investment vehicles, including mutual funds, exchange-traded funds (ETFs), and derivative securities. We charge licensing fees for the Morningstar Indexes, with fees consisting of an annual licensing fee as well as fees linked to assets under management.

 

We currently license the Morningstar Indexes to several institutions which offer exchange-traded funds or exchange-traded notes based on the indexes, including Barclays Global Investors, First Trust, and Claymore Investments.

 

In 2007, we introduced a series of commodity indexes, which consists of five indexes providing diversified commodity exposure; the Morningstar Bond Index Family, which consists of 14 indexes that track the U.S. bond market by sector and term structure; and the Morningstar Wide Moat Focus Index, which is composed of 20 wide moat stocks with the best valuations as measured by the Morningstar price/fair value ratio. In 2007, the ELEMENTS platform launched exchange-traded notes (ETNs) based on the Wide Moat Focus Index that trade on the New York Stock Exchange. The ETNs are issued by Deutsche Bank and distributed by Nuveen Investments and Merrill Lynch.

 

Marketing and Sales

 

We promote our print, software, Web-based products and services, and consulting services with a staff of sales and marketing professionals, as well as an in-house public relations team. Our marketing staff includes both product specialists and a corporate marketing group that manages company initiatives. Our sales team includes several strategic account managers who oversee all aspects of our largest institutional client relationships. We also have a sales operations staff, which focuses on tracking revenue, forecasting sales, and other tasks to support our sales team. Across all three of our segments, we emphasize high levels of product support to help our customers use our products effectively and provide our product managers with feedback from customers. We had approximately 250 sales and marketing professionals on staff as of December 31, 2007.

 

International Operations

 

We conduct our business operations outside of the United States through wholly owned or majority-owned operating subsidiaries doing business in each of the following countries: Australia, Canada, France, Germany, India, Italy, Japan, the Netherlands, New Zealand, Norway, People’s Republic of China (both Hong Kong and the mainland), Singapore, Spain, Switzerland, Taiwan, Thailand, and the United Kingdom. See Note 5 of the Notes to our Consolidated Financial Statements for additional information concerning revenue from customers and long-lived assets from our business operations outside the United States.

 

In addition, we hold minority ownership positions in operating companies based in Denmark, Japan, Korea, and Sweden. As of December 31, 2007, we owned approximately 35% of the outstanding shares in Morningstar Japan K.K. (Morningstar Japan) and our share had a market value of approximately $48 million. Morningstar Japan is publicly traded under ticker 4765 on the Osaka Stock Exchange “Hercules Market.” See Note 8 of the Notes to our Consolidated Financial Statements for information on our investments in unconsolidated entities.

 

To enable these companies to do business in their designated territories, we provide them with the rights to the Morningstar name and logo and with access to certain of our products and technology. Each company is responsible for developing marketing plans tailored to meet the specific needs of investors within its country and working with Morningstar’s data collection and development centers to create and maintain databases, develop new products, and enhance existing products.

 

See Item 1A—Risk Factors for a discussion of the risks related to our business operations outside of the United States.

 

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Intellectual Property and Other Proprietary Rights

 

We treat our brand, product names and logos, software, technology, databases, and other products as proprietary. We try to protect this intellectual property by using trademark, copyright, patent and trade secrets laws, licensing and nondisclosure arrangements, and other security measures. For example, in the normal course of business, we only provide our intellectual property to third parties through standard licensing agreements. The purposes of these agreements are to both define the extent and duration of any third-party usage rights and to provide for our continued ownership in any intellectual property furnished.

 

Because of the value of our brand name and logo, we have tried to register one or both of them in all of the relevant international classes under the trademark laws of most of the jurisdictions in which we do business. As we move into new countries, we consider adding to these registrations and, in some jurisdictions, register certain product identifiers as well. We have registered our name and/or logo in numerous countries and the European Union and have applied for registrations in several other countries.

 

We currently hold three U.S. patents, one U.K. patent, and one Canadian patent. We believe these patents represent our commitment to developing innovative products and tools for investors.

 

From time to time, we encounter jurisdictions in which one or more third parties have a pre-existing trademark registration in certain relevant international classes that may prevent us from registering our own marks in those jurisdictions. It is possible that our continued ability to use the “Morningstar” name or logo, either on a stand-alone basis or in association with certain products or services, could be compromised in those jurisdictions because of these pre-existing registrations. Similarly, from time to time, we encounter situations in certain jurisdictions where one or more third parties are already using the Morningstar name, either as part of a registered corporate name, a registered domain name or otherwise. It is possible that our ability to continue to effectively market certain of our products and/or services could be adversely affected by these usages.

 

“Morningstar” and the Morningstar logo are registered marks of Morningstar in the United States and in certain other jurisdictions. The following are also trademarks or service marks of our company in the United States:

 

Advice by Ibbotson®

 

Morningstar® Managed PortfoliosSM Select Stock Baskets

Morningstar® Advisor WorkstationSM

 

Morningstar® Mutual FundsTM

Morningstar.com®

 

Morningstar® Ownership ZoneSM

Morningstar DirectSM

 

Morningstar® Portfolio BuilderSM

Morningstar® EnCorr®

 

Morningstar® Principia®

Morningstar® Equity Research

 

Morningstar RatingTM

Morningstar® ETFInvestorTM

 

Morningstar® Retirement Income StrategistSM

Morningstar® ETFs 150TM

 

Morningstar® Retirement ManagerSM

Morningstar® FundInvestorTM

 

Morningstar® Stewardship GradeSM

Morningstar® Funds 500TM

 

Morningstar® StockInvestorTM

Morningstar® IndexesSM

 

Morningstar® Stocks 500TM

Morningstar® Investment GuidesTM

 

Morningstar Style BoxTM

Morningstar® Investment ProfilesTM

 

Morningstar® Wide Moat FocusSM Index

Morningstar® Licensed DataSM

 

Portfolio X-Ray®

Morningstar® Managed PortfoliosSM

 

Stocks, Bonds, Bills, and Inflation®

 

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License Agreements

 

In the majority of our licensing agreements, we license our products and/or other intellectual property to our customers for a fee. We generally use our standard agreements, whether in paper or electronic form, and we do not provide our products and services to customers or other users without having an agreement in place.

 

We maintain licensing agreements with each of our minority-owned operations.  We put these agreements in place so these companies can use our intellectual property, such as our products and trademarks, to develop and market similar products under our name in their operating territories.

 

We license certain intellectual property from third parties, and in the ordinary course of our business, we incorporate and use intellectual property from a variety of third-party sources.

 

Seasonality

 

We believe our business has a modest amount of seasonality. Most of our products are sold with subscription or license terms of at least one year, and we recognize revenue ratably over the term of each subscription or license agreement. This tends to moderate seasonality in sales patterns for individual products. Over the past three years, sequential revenue growth at the company level on a consolidated basis in the first quarter has been slightly higher than in other quarters. Refer to the discussion in Business Segments, Products, and Services above for additional information on the seasonality of each segment.

 

Customers

 

In 2007, our largest customer accounted for less than 5% of our consolidated revenue.

 

Competitive Landscape

 

The economic and financial information industry has been marked by increased consolidation over the past five years, with the strongest players generally gaining market share at the expense of smaller competitors. Our largest competitors are Lipper (a division of Reuters), Standard & Poor’s, and Thomson Financial Services. These companies have financial resources that are significantly greater than ours. In May 2007, Thomson and Reuters entered into an agreement to form a combined company, Thomson-Reuters. Pending regulatory approval, the two companies expect to complete the merger in the second quarter of 2008. The proposed formation of Thomson-Reuters would create a larger company with greater financial resources. We also have a number of smaller competitors in each of our three business segments; for more information, refer to the discussion in Business Segments, Products, and Services above. Most of our competitors compete with individual products or segments of our business; we are not aware of any company that offers substantially similar product solutions in all three of our segments.

 

Our operations outside the United States compete with a variety of other companies not named above, including Financial Express, Interactive Data Corporation, IWL Limited, MoneyMate,Telekurs, Towers Perrin, and van Eyk Research.

 

We believe the most important competitive factors in our industry are brand and reputation, data accuracy and quality, breadth of data coverage, quality of investment analysis and analytics, design, product reliability, and value of the products and services provided.

 

Research and Development

 

A key aspect of our growth strategy is to expand our investment research capabilities and enhance our existing products and services. We strive to rapidly adopt new technology that can improve our products and services. We have also built a flexible technology platform that allows our products to work together across a full range of investment databases, delivery formats, and market segments. As a general practice, we manage our own Web sites and build our own software applications rather than relying on outside vendors. This allows us to control our development and better manage costs, enabling us to respond quickly to market changes and to meet customer needs efficiently. As of December 31, 2007, our technology team consisted of approximately 400 programmers and technology and infrastructure professionals.

 

In 2007, 2006, and 2005, our development expense represented 8.1%, 9.4%, and 8.7%, respectively, of our revenue. We expect that development expense will continue to represent a meaningful percentage of our revenue in the future.

 

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Government Regulation

 

United States

 

Our investment advisory and broker-dealer businesses are subject to extensive regulation in the United States at both the federal and state level, as well as by self-regulatory organizations. Financial services companies are among the nation’s most extensively regulated. The Securities and Exchange Commission (SEC) is responsible for enforcing the federal securities laws and serves as a supervisory body for all federally registered investment advisors and broker-dealers.

 

As of December 31, 2007, four of our subsidiaries, Ibbotson Associates, Inc., Ibbotson Associates Advisors, LLC, Morningstar Associates, LLC, and Morningstar Investment Services, Inc. are registered as investment advisors with the SEC under the Investment Advisers Act of 1940 (Advisers Act). As registered investment advisors, these companies are subject to the requirements and regulations of the Advisers Act. Such requirements relate to, among other things, record-keeping and reporting requirements, disclosure requirements, and limitations on principal transactions between an advisor and advisory clients, as well as general anti-fraud prohibitions.

 

Because Morningstar Associates and Ibbotson Associates provide investment advisory services to retirement plans and their participants, they may be acting as fiduciaries under the Employee Retirement Income Security Act of 1974 (ERISA). As fiduciaries under ERISA, Morningstar Associates and Ibbotson Associates have duties of loyalty and prudence, as well as duties to diversify investments and to follow plan documents to comply with the applicable portions of ERISA.

 

We provide each of our investment advisor companies with financial and operational support. However, each of them operates independently from other areas of Morningstar, using separate personnel and making independent investment decisions.

 

Morningstar Investment Services is a broker-dealer registered under the Securities Exchange Act of 1934 (Exchange Act) and a member of the Financial Industry Regulatory Authority, Inc. (FINRA). The regulation of broker-dealers has, to a large extent, been delegated by the federal securities laws to self-regulatory organizations, including FINRA. Subject to approval by the SEC, FINRA adopts rules that govern its members. FINRA conducts periodic examinations of the operations of Morningstar Investment Services. Broker-dealers are subject to regulations that cover all aspects of the securities business, including sales practices, market making and trading among broker-dealers, use and safekeeping of clients’ funds and securities, capital structure, record-keeping, and the conduct of directors, officers, and employees. Violation of applicable regulations can result in the revocation of a broker-dealer license, the imposition of censures or fines, and the suspension or expulsion of a firm or its officers or employees. Morningstar Investment Services is subject to certain net capital requirements under the Exchange Act. The net capital requirements, which specify minimum net capital levels for registered broker-dealers, are designed to measure the financial soundness and liquidity of broker-dealers.

 

Additional legislation and regulations, including those relating to the activities of investment advisors and broker-dealers, changes in rules imposed by the SEC or other U.S. or non-U.S. regulatory authorities and self regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may adversely affect our business and profitability. Our businesses may be materially affected not only by regulations applicable to it as an investment advisor or broker-dealer, but also by regulations that apply to companies generally.

 

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Australia

 

In order to provide financial information services in Australia, our Australian subsidiaries, Morningstar Research Pty Limited (Morningstar Australia) and Huntley’s Investment Information Pty Limited, must hold an Australian Financial Services License and submit to the jurisdiction of the Australian Securities and Investments Commission (ASIC). This license requires Morningstar Australia and Huntley’s Investment Information Pty Limited to maintain positive net asset levels and sufficient cash resources to cover three months of expenses and to comply with the audit requirements of the ASIC.

 

United Kingdom

 

Morningstar Associates Europe Limited is authorized and regulated by the U.K. Financial Services Authority as an investment advisor. As an authorized firm, this company is subject to the requirements and regulations of the Financial Services Authority. Such requirements relate to, among other things, financial reporting and other reporting obligations, record keeping, and cross-border requirements.

 

Employees

 

We had approximately 1,720 employees as of December 31, 2007, including approximately 240 investment analysts (including consulting and quantitative research analysts), 300 data analysts, 400 programmers and technology staff, 40 designers, and 250 sales and marketing professionals. Our employees are not represented by any unions and we have never experienced a walkout or strike.

 

Executive Officers

 

As of March 1, 2008, we had 13 executive officers. The table below summarizes information about each of these officers.

 

Name

 

Age

 

Position

Joe Mansueto

 

51

 

Chairman, Chief Executive Officer, and Director

Chris Boruff

 

42

 

President, Advisor Business

Peng Chen

 

37

 

President and Chief Investment Officer, Ibbotson Associates

Scott Cooley

 

39

 

Chief Financial Officer

Bevin Desmond

 

41

 

President, International Business

Catherine Gillis Odelbo

 

45

 

President, Individual Business

Tao Huang

 

45

 

Chief Operating Officer

Elizabeth Kirscher

 

43

 

President, Data Services Business

Don Phillips

 

45

 

Managing Director and Director

Patrick Reinkemeyer

 

42

 

President, Morningstar Associates

John Rekenthaler

 

47

 

Vice President, Research and New Product Development

Richard Robbins

 

45

 

General Counsel and Corporate Secretary

David W. Williams

 

47

 

Managing Director, Design

 

Joe Mansueto

 

Joe Mansueto founded Morningstar in 1984. He has served as our chairman since our inception and as our chief executive officer from our inception to 1996 and from 2000 to the present. He holds a bachelor’s degree in business administration from The University of Chicago and a master’s degree in business administration from The University of Chicago Graduate School of Business.

 

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Chris Boruff

 

Chris Boruff has been the president of our advisor business since 2000. He is responsible for overseeing strategy, development, and marketing associated with our products for financial advisors. He joined us in 1996 as product manager for Principia, and from 1997 to 1998, he served as senior product manager of advisor products. From 1999 to 2000, he served as vice president of advisor products, where he was responsible for all marketing related to financial advisors. He holds a bachelor’s degree in economics and psychology from Northwestern University.

 

Peng Chen

 

Peng Chen has been president and chief investment officer of Ibbotson Associates since August 2006. Prior to Morningstar’s acquisition of Ibbotson, he served as Ibbotson’s managing director and chief investment officer. He joined Ibbotson in 1997 and played a key role in the development of its investment consulting and 401(k) advice/managed retirement account services. He received a bachelor’s degree in industrial management engineering from Harbin Institute of Technology and a master’s and doctorate in consumer economics from The Ohio State University.

 

Scott Cooley

 

Scott Cooley has been our chief financial officer since August 2007. Before joining Morningstar in 1996 as a stock analyst, he was a bank examiner for the Federal Deposit Insurance Corporation (FDIC), where he focused on credit analysis and asset-backed securities. From 1996 until 2003, he was an analyst, editor, and manager for Morningstar.com, Morningstar Mutual Funds, and other Morningstar publications. He became CEO of Morningstar Australia and Morningstar New Zealand in 2003 and served as co-CEO of these operations following our acquisition of Aspect Huntley in July 2006. He holds a bachelor’s degree in economics and social science and a master’s degree in history from Illinois State University.

 

Bevin Desmond

 

Bevin Desmond has been president of our international business since 2000. She is responsible for identifying and developing our business in new countries, managing and directing operations, and launching new products. She joined us in 1993 and was one of three employees who started our international business. From 1998 to 2000, she served as manager of all international ventures. She holds a bachelor’s degree in psychology from St. Mary’s College.

 

Catherine Gillis Odelbo

 

Catherine Gillis Odelbo has been president of our Individual segment since 2000. She joined us in 1988 as a mutual fund analyst and from 1999 to 2000 served as senior vice president of content development for the company, as well as publisher and editor of our stock and closed-end fund research. She holds a bachelor’s degree in American history from The University of Chicago and a master’s degree in business administration from The University of Chicago Graduate School of Business.

 

Tao Huang

 

Tao Huang has been our chief operating officer since 2000. He is responsible for corporate strategy, oversight of all business units, and directing our day-to-day operations. He joined us in 1990 as a software developer and from 1996 to 1998 served as chief technology officer. From 1998 to 2000, he served as senior vice president of business development and head of international operations. He holds a bachelor’s degree in computer science from Hunan University in China, a master’s degree in computer science from Marquette University, and a master’s degree in business administration from The University of Chicago Graduate School of Business.

 

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Elizabeth Kirscher

 

Elizabeth Kirscher has been president of our data services business since 2000. She is responsible for managing our investment databases and related products. She joined us in 1995 as a major accounts manager in our institutional sales area. From 1998 to 1999, she served as international product manager and worked on the launch of Morningstar Japan. From 1999 to 2000, she was director of sales and business development for Morningstar.com and marketed Morningstar.com data and tools to other Web sites. She holds a bachelor’s degree from Vassar College and a master’s degree in business administration from the Columbia Business School at Columbia University.

 

Don Phillips

 

Don Phillips has been one of our managing directors since 2000. He is responsible for corporate strategy, research, and corporate communications. He joined us in 1986 as our first analyst. He served as our vice president and publisher from 1991 to 1996, as our president from 1996 to 1998, and as our chief executive officer from 1998 to 2000. He has served on our board of directors since August 1999. He also serves on the board of directors for Morningstar Japan. He holds a bachelor’s degree in English from the University of Texas and a master’s degree in American literature from The University of Chicago.

 

Patrick Reinkemeyer

 

Patrick Reinkemeyer has been president of Morningstar Associates since October 2004. He is responsible for Morningstar’s investment consulting and retirement businesses. He joined us in 1996 and directed our print and software variable annuity/life products from 1996 to 1997. From 1998 until 2001, he was director of Morningstar’s investment consulting business. From 2001 until October 2004, he served as president of investment consulting.  He holds a bachelor’s degree in history from Middlebury College and a master’s degree in business administration from The University of Chicago Graduate School of Business.

 

John Rekenthaler

 

John Rekenthaler has been vice president of new product development since October 2004. In April 2005, he took on additional responsibilities as vice president of research. From 2001 until October 2004, he served as president of Morningstar Associates and head of the company’s retirement advice business. He joined us in 1988 as an assistant editor. From 1991 to 1995, he served as editor of Morningstar Mutual Funds and Morningstar FundInvestor. From 1998 to 2000, he served as our director of research. He holds a bachelor’s degree in English from the University of Pennsylvania and a master’s degree in business administration from The University of Chicago Graduate School of Business.

 

Richard Robbins

 

Richard Robbins has been our general counsel and corporate secretary since August 2005. He is responsible for directing Morningstar’s legal department and managing our relationships with outside counsel. From May 1999 until he joined Morningstar, he was a partner at Sidley Austin Brown & Wood LLP (now known as Sidley Austin LLP), which he joined as an associate in August 1991. He holds bachelor’s and master’s degrees in computer science and electrical engineering from the Massachusetts Institute of Technology and a juris doctor degree from The University of Chicago Law School.

 

David W. Williams

 

David W. Williams has been one of our managing directors since 2000. He is in charge of design and its application to brand identity, products, communications, and the workplace. He joined us in 1993 and has been instrumental in establishing design as one of our recognized core capabilities. He holds a bachelor’s degree in industrial design from The Ohio State University and a master’s degree in fine arts from the Yale University School of Art.

 

 

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Company Information

 

We were incorporated in Illinois on May 16, 1984. Our corporate headquarters are located at 225 West Wacker Drive, Chicago, Illinois, 60606.

 

We maintain a Web site at http://corporate.morningstar.com. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to any of these documents are available free of charge on this site as soon as reasonably practicable after the reports are filed with or furnished to the Securities and Exchange Commission. We also post quarterly press releases on our financial results and other documents containing additional information related to our company on this site. We provide this Web site and the information contained in or connected to it for informational purposes only. That information is not part of this Annual Report on Form 10-K.

 

Item 1A. Risk Factors

 

You should carefully consider the risks described below and all of the other information included in this Form 10-K when deciding whether to invest in our common stock or otherwise evaluating our business. If any of the following risks materialize, our business, financial condition, or operating results could suffer. In this case, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Competition could reduce our share of the investment research market and hurt our financial performance.

 

We operate in a highly competitive industry, with many investment research providers competing for business from individual investors, financial advisors, and institutional clients. We compete with many different types of companies that vary in size, product scope, and media focus, including large and well-established distributors of financial information, such as Lipper, a division of Reuters; The McGraw-Hill Companies, through its Standard & Poor’s division; and Thomson Corporation, through its Thomson Financial Services division. In May 2007, Thomson and Reuters entered into an agreement to form a combined company, Thomson-Reuters. Pending regulatory approval, the two companies expect to complete the merger in the second quarter of 2008. The proposed formation of Thomson-Reuters would create a larger company with greater financial resources. In addition to these key competitors, we compete with a variety of other companies in different areas of our business, which we discuss in greater detail in the Business Segments, Products, and Services section in Item 1—Business.

 

Many of our competitors have larger customer bases and significantly greater resources than we do. This may allow these competitors to respond more quickly to new technologies and changes in demand for products and services, to devote greater resources to developing and promoting their services, and to make more attractive offers to potential clients, subscribers, and strategic partners. Industry consolidation may also lead to more intense competition. Increased competition could result in price reductions, reduced gross margins, or loss of market share, any of which could hurt our business, operating results, or financial condition.

 

If we do not maintain and increase the number of subscriptions and license agreements, our operating results could suffer.

 

A substantial portion of our revenue is generated from subscriptions and license agreements. In general, our subscriptions are paid in advance. We may be obligated to refund a portion of prepaid subscription fees when a customer cancels. Cancellations may have a negative impact on our revenue and cash position. Our license agreements, which typically do not allow for cancellation, have terms ranging from one to three years. Our future success depends on our maintaining (through renewals) and increasing (through new subscriptions and license agreements) the number of customers who pay for our investment research and services. Further, if the market for our products and services develops more slowly than we expect, or declines, and the number of customers who pay for our services does not increase, or declines, our business, operating results, or financial condition could suffer.

 

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Certain products and services have historically made up a large percentage of our revenue base. Our business could suffer if sales of these products and services decline.

 

In 2007, our five largest products based on revenue (Investment Consulting, Licensed Data, Morningstar Advisor Workstation, Morningstar.com, and Principia) accounted for approximately 60% of our consolidated revenue. We believe that sales of these products and services will continue to make up a substantial portion of our consolidated revenue for the foreseeable future. If we experience a significant decline in sales of any of these products for any reason, it would have a material adverse impact on our revenue and could harm our business.

 

The independent equity research we’re providing to six investment banks under the terms of the Global Analyst Research Settlement accounted for approximately 5% of our consolidated revenue in 2007. The period during which investment banks are required to provide independent equity research to their clients will expire in July 2009. After the settlement period expires, the investment banks covered by it will no longer be required to provide independent investment research to their clients. We don’t know how much, if any, of this equity research revenue we’ll be able to retain or replace following the end of the settlement period in July 2009. Because these contracts include both renewal and cancellation options and the firms named in the settlement are free to choose from a variety of research providers, we also cannot guarantee that we will retain this business for any period prior to July 2009.

 

Changes in market and economic conditions could lower demand for our products and services.

 

Conditions in the financial and securities markets may have an impact on our performance. For example, in the event that the U.S. or international financial markets suffers a severe or prolonged downturn, demand for our products and services may decline, and our revenue and profitability levels could suffer. The financial markets and many businesses operating in the financial services industry are highly volatile and are affected by factors, such as U.S. and foreign economic conditions and general trends in business and finance, which are beyond our control.

 

Our revenue from asset-based fees could be affected by a decline in the equity market.

 

Our fee-based asset management business has continued to increase as a percentage of total revenue and become more important to our financial results. In 2007, revenue from asset-based fees made up approximately 16% of our consolidated revenue and a greater percentage of our operating income. During periods of significant market volatility, net inflows into the portfolios on which we provide investment advisory services may decrease, or these portfolios may experience redemptions or substantial declines in value. If the level of assets on which we provide investment advisory services declines, we expect that our fee-based revenue will show a corresponding decline.

 

Our results could suffer if the mutual fund industry experiences a lower growth rate than in the past.

 

A significant portion of our revenue is generated from products and services related to mutual funds. The mutual fund industry has experienced substantial growth over the past 20 years. Mutual fund assets may not continue to expand at the same rate in future years. Settlements and regulatory actions in the mutual fund industry following the market-timing scandal that emerged in 2003, downturns or volatility in the financial markets, or a relative increase in use of other investment vehicles could cause a decline in investor interest in mutual funds. A slower growth rate of mutual fund assets could decrease demand for some of our products.

 

Our reputation and business may be harmed by allegations made about possible conflicts of interest.

 

We offer products and services to our institutional clients, which include banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors. Our institutional business generated revenue, before intersegment eliminations, of $230.3 million, or 52.9% of our consolidated revenue, in 2007, and $146.1 million, or 46.4% of our consolidated revenue, in 2006. We provide ratings, analyst research, and investment recommendations on mutual funds and other investment products offered and securities issued by our institutional clients. The fact that our institutional clients pay us for certain products and services may create the perception that our ratings, research, and recommendations are not impartial. This perception may undermine the confidence of our customers and potential customers in our reputation as a provider of independent research. Any such loss of confidence or damage to our reputation could hurt our business.

 

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Our investment advisory operations may subject us to liability for any losses that result from a breach of our fiduciary duties.

 

Our investment advisory operations involve fiduciary obligations that require us to act in the best interests of our clients. We may face liabilities for actual or claimed breaches of our fiduciary duties. We may not be able to prevent clients from taking legal action against us for an actual or claimed breach of a fiduciary duty. Because we currently provide investment advisory services on more than $97.5 billion in assets, we could face substantial liabilities if we breach our fiduciary duties. In addition, we may face other legal liabilities based on the quality and outcome of our investment advisory recommendations, even in the absence of an actual or claimed breach of fiduciary duty.

 

Changes in laws applicable to our investment advisory operations, compliance failures, or regulatory action could adversely affect our business.

 

Our investment advisory operations are relatively new and a growing part of our overall business. Our acquisition of Ibbotson Associates in 2006 substantially increased our business in this area. The securities laws and other laws that govern our activities as a registered investment advisor are complex. The activities of our investment advisory operations are primarily subject to provisions of the Investment Advisers Act of 1940 (the Advisers Act) and the Employee Retirement Income Security Act of 1974 (ERISA). In addition, our investment management business is conducted through a broker-dealer registered under the Securities Exchange Act of 1934 (the Exchange Act) and is subject to the rules of the Financial Industry Regulatory Authority, Inc. (FINRA). It is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting our business. The laws, rules, and regulations applicable to our business may change in the future and we may not be able to comply with any such changes. If we fail to comply with any applicable law, rule, or regulation, we could be fined, sanctioned, or barred from providing investment advisory services in the future, which could materially adversely affect our business, operating results, or financial condition.

 

We could be subject to fines, penalties, or other sanctions as a result of investigations by the New York Attorney General’s Office and the Department of Labor related to some of the services Morningstar Associates, LLC provides.

 

As previously disclosed, the New York Attorney General’s Office and the Department of Labor are conducting separate investigations related to some of the products and services offered by Morningstar Associates, LLC. See Item 3—Legal Proceedings for a description of these matters. We cannot predict the scope, timing, or outcome of these matters, which may include the institution of administrative, civil, injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key employees, and the loss of customers. We also cannot predict what impact, if any, these matters may have on our business, operating results, or financial condition. We have not established any reserves relating to these matters.

 

Political and regulatory issues may adversely affect our data and technology development center based in Shenzhen, China.

 

We now have approximately 300 programmers and data analysts working in our development center in China. Over the past several years, we have been moving a significant percentage of our data collection and development operations to this location. Because China has a restrictive government under centralized control, we cannot predict the level of political and regulatory risk that may affect our operations. Any difficulties that we face in successfully maintaining our development center in China may harm our business and have a negative impact on the products and services we provide.

 

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Our operations outside of the United States are expanding and involve special challenges that we may not be able to meet.

 

Over the past three years, our operations outside of the United States have generated an increasing amount of revenue, expanding to $89.7 million in 2007 from $29.4 million in 2005. Our 2006 acquisition of Aspect Huntley in Australia, our 2007 acquisition of the mutual fund data business from Standard & Poor’s, and our January 2008 acquisition of the Hemscott data, media, and investor relations businesses substantially increased our business operations in Europe, Australia, and other areas outside the United States. As mentioned above, we have approximately 300 programmers and data analysts working in our development center in China. Following the Hemscott acquisition, we have approximately 200 additional employees employed at a data collection facility in New Delhi, India. There are risks inherent in doing business outside the United States, including challenges in reaching new markets because of established competitors; difficulties in staffing, managing, and integrating non-U.S. operations; differences in laws and policies from country to country; exposure to varying legal standards, including intellectual property protection laws; and currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.

 

We do not currently hedge any of our currency exposure, which may adversely impact our financial results.

 

As our non-U.S. revenue increases as a percentage of our consolidated revenue, fluctuations in foreign currencies present a greater potential risk. To date, we have not engaged in currency hedging, and we do not currently have any positions in derivative instruments to hedge our currency risk. Our reported revenue could suffer if certain foreign currencies decline relative to the U.S. dollar, although the impact on operating income may be offset by an opposing currency impact on locally based operating expense. In addition, because we use the local currency of our subsidiaries as the functional currency, our financial results are affected by the translation of foreign currencies into U.S. dollars.

 

Higher capital spending may adversely impact our free cash flow.

 

We expect that our 2008 capital spending will be significantly higher than in previous years because of spending for our new corporate headquarters in Chicago. Higher capital expenditures may reduce the amount of cash available for investment in other areas, such as computer equipment, reinvestment in the business, and employee bonuses.

 

Stock option exercises and other factors may create volatility in our cash flows.

 

Our cash provided by financing activities primarily consists of proceeds from stock option exercises and excess tax benefits related to stock option exercises and vesting of restricted stock units. Excess tax benefits occur at the time a stock option is exercised if the intrinsic value of the option (the difference between the exercise price of the option and the fair value of our stock on the date of exercise) exceeds the fair value of the option at the time of grant. Similarly, excess tax benefits are generated upon vesting of restricted stock units when the market value of our common stock at vesting is greater than the grant price of the restricted stock units. These excess tax benefits reduce the cash we pay for income taxes in the year they are recognized.  It is not possible to predict the timing of stock option exercises nor the intrinsic value that will be achieved. Because of this uncertainty, there may be additional volatility in our cash flows from financing activities from year to year.

 

A prolonged outage of our database and network facilities could result in reduced revenue and the loss of customers.

 

The success of our business depends upon our ability to deliver time-sensitive, up-to-date data and information. We rely on our computer equipment, database storage facilities, and other office equipment, which are mainly located in our Chicago headquarters or elsewhere in the Chicago area. Our operations and those of our suppliers and customers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks, wars, Internet failures, computer viruses, and other events beyond our control, including disasters affecting Chicago. We maintain off-site back-up facilities for our database and network equipment, but these facilities could be subject to the same interruptions that may affect our headquarters. We’re not currently able to immediately switch over all of our systems to a back-up facility. If we experience a significant database or network facility outage, our business may be disrupted until we fully implement our back-up systems. Any losses, service disruption, or damages incurred by us could have a material adverse effect on our business, operating results, or financial condition.

 

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Our business relies heavily on electronic delivery systems and the Internet. Any failures or disruptions could result in reduced revenue and the loss of customers.

 

Most of our products and services depend heavily on our electronic delivery systems and the Internet. Our ability to deliver information using the Internet may be impaired because of infrastructure failures, service outages at third-party Internet providers, or increased government regulation. If disruptions, failures, or slowdowns of our electronic delivery systems or the Internet occur, our ability to distribute our products and services effectively and to serve our customers may be impaired.

 

We could face liability related to our storage of personal information about our users.

 

Customers routinely input personal investment and financial information, including portfolio holdings and credit card information, on our Web sites. We could be subject to liability if we were to inappropriately disclose any user’s personal information or if third parties were able to penetrate our network security or otherwise gain access to any user’s name, address, portfolio holdings, or credit card information. Any such event could subject us to claims for unauthorized credit card purchases, impersonation or other similar fraud claims, or claims for other misuses of personal information, such as unauthorized marketing or unauthorized access to personal portfolio information.

 

The availability of free or low-cost investment information could lead to lower demand for our products and adversely affect our financial results.

 

Investment research and information relating to publicly traded companies and mutual funds is widely available for little or no cost from various sources, including the Internet and public libraries. Investors can also access information directly from publicly traded companies and mutual funds. The EDGAR database available through the Securities and Exchange Commission (SEC) Web site provides real-time access to SEC filings, including annual, semi-annual, and quarterly reports. Many brokerage firms also provide financial and investment research to their clients. The widespread availability of free or low-cost investment information may make it difficult for us to maintain or increase the prices we charge for our publications and services and could lead to a lower demand for our products. A loss of a significant number of customers would hurt our financial results.

 

Our failure to successfully integrate acquisitions could strain our resources.

 

We’ve completed several acquisitions over the past three years, including our 2007 acquisition of the mutual fund data business from Standard & Poor’s and our January 2008 acquisition of the Hemscott data, media, and investor relations businesses. We cannot guarantee that we will successfully integrate the employees, product lines, business systems, and operations following any acquisition. We expect to continue making acquisitions and establishing investments and joint ventures as part of our long-term business strategy. Acquisitions, investments, and joint ventures involve a number of risks. They can be time-consuming and may divert management’s attention from day-to-day operations. Financing an acquisition could result in dilution from issuing equity securities, reduce our financial flexibility because of reductions in our cash balance, or result in a weaker balance sheet from incurring debt.

 

Acquisitions might also result in losing key employees. We may fail to successfully complete an acquisition, investment, or joint venture. We may also fail to generate enough revenue or profits from an acquisition to earn a return on the associated purchase price.

 

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We could face liability for the information we publish, including information based on data we obtain from other parties.

 

We may be subject to claims for securities law violations, defamation (including libel and slander), negligence, or other claims relating to the information we publish. For example, investors may take legal action against us if they rely on published information that contains an error, or a company may claim that we have made a defamatory statement about it or its employees. We could also be subject to claims based upon the content that is accessible from our Web site through links to other Web sites. We rely on a variety of outside parties as the original sources for the information we use in our published data. These sources include securities exchanges, fund companies, and transfer agents. Accordingly, in addition to possible exposure for publishing incorrect information that results directly from our own errors, we could face liability based on inaccurate data provided to us by others. Defending claims based on the information we publish could be expensive and time-consuming and could adversely impact our business, operating results, and financial condition.

 

Our future success depends on our ability to recruit and retain qualified employees, including our executive officers.

 

We experience competition for analysts and other employees from financial institutions and financial services organizations. These organizations generally have greater resources than we do and therefore may be able to offer significantly more attractive compensation packages to potential employees. Competition for these employees is intense, and we may not be able to retain our existing employees or be able to recruit and retain other highly qualified personnel in the future.

 

Our future success also depends on the continued service of our executive officers, including Joe Mansueto, our chairman, chief executive officer, and controlling shareholder. The loss of one or more of our executive officers could hurt our business, operating results, or financial condition. We do not carry any life insurance on our executive officers. We do not have employment agreements or non-compete agreements in place with any of our executive officers. They may leave us and work for our competitors or start their own competing businesses.

 

Failure to protect our intellectual property rights could harm our brand-building efforts and ability to compete effectively.

 

The steps we have taken to protect our intellectual property may not be adequate to safeguard our proprietary information. Further, effective trademark, copyright, and trade secret protection may not be available in every country in which we offer our services. Our continued ability to market one or more of our products under their current names could be adversely affected in those jurisdictions where another person registers, or has a pre-existing registration on, one or more of them. Failure to adequately protect our intellectual property could harm our brand, devalue our proprietary content, and affect our ability to compete in the marketplace.

 

Control by a principal shareholder could adversely affect our other shareholders.

 

As of December 31, 2007, Joe Mansueto, our chairman and chief executive officer, owned approximately 63% of our outstanding common stock. As a result, he has the ability to control substantially all matters submitted to our shareholders for approval, including the election and removal of directors and any merger, consolidation, or sale of our assets. He also has the ability to control our management and affairs. This concentration of ownership may delay or prevent a change in control; impede a merger, consolidation, takeover, or other business combination involving us; discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us; or result in actions that may be opposed by other shareholders.

 

Moreover, because of Joe’s substantial ownership, we are a “controlled company” for purposes of the NASDAQ Marketplace Rules. This means that, if in the future we elect to be treated as a controlled company under the NASDAQ Marketplace Rules, we will not be required by NASDAQ to have a majority of independent directors or to maintain compensation and nominating and corporate governance committees composed entirely of independent directors to continue to list our shares on NASDAQ.

 

29



 

Fluctuations in our operating results may negatively impact our stock price.

 

We believe our business has relatively large fixed costs and low variable costs, which magnify the impact of revenue fluctuations on our operating results. As a result, a decline in our revenue may lead to a larger decline in operating income. A substantial portion of our operating expense is related to personnel costs, marketing programs, and corporate overhead, none of which can be adjusted quickly. Our operating expense levels are based on our expectations for future revenue. If actual revenue falls below our expectations, or if our expenses increase before revenues do, our operating results would be materially and adversely affected. In addition, we do not provide earnings guidance or hold one-on-one meetings with institutional investors and research analysts. Because of this policy and limited analyst coverage on our stock, our stock price may be volatile. If our operating results or other operating metrics fail to meet the expectations of outside research analysts and investors, the market price of our common stock may decline.

 

The future sale of shares of our common stock may negatively impact our stock price.

 

If our shareholders sell substantial amounts of our common stock, the market price of our common stock could fall. A reduction in ownership by Joe Mansueto or any other large shareholder could cause the market price of our common stock to fall. In addition, the average daily trading volume in our stock is relatively low. The lack of trading activity in our stock may lead to greater fluctuations in our stock price. Low trading volume may also make it difficult for shareholders to make transactions in a timely fashion.

 

Our shareholders may experience dilution in their ownership positions.

 

In the past, we’ve granted options to employees as a significant part of their overall compensation package. In 2006 we began granting restricted stock units to our employees and non-employee directors. As of December 31, 2007, our employees and non-employee directors held options to acquire 6,445,679 shares of common stock, 5,610,008 of which were exercisable at a weighted average exercise price of approximately $12.45 per share and 835,671 were not exercisable. As of December 31, 2007, there were 420,903 restricted stock units outstanding. Of these, 122,967 are scheduled to vest in 2008, 122,967 in 2009, 119,669 in 2010, and 55,300 in 2011. Generally speaking, a share is issued when a restricted stock unit vests. Some holders have elected to defer when shares are issued and many holders satisfy tax withholding obligations by forfeiting the right to have some of their shares issued. To the extent that option holders exercise outstanding options to purchase common stock and to the extent that shares are issued when restricted stock units vest, there will be further dilution. Future grants of stock options or restricted stock units may also result in dilution. We may raise additional funds through future sales of our common stock. Any such financing would result in additional dilution to our shareholders.

 

Item 1B. Unresolved Staff Comments

 

We have not received any comments from the Staff of the Securities and Exchange Commission regarding our periodic or current reports under the Exchange Act.

30



 

Item 2. Properties

 

Offices for our U.S. operations are located in Chicago, Illinois, and as of December 31, 2007 consisted of approximately 187,000 square feet of leased space. In 2008, we will move our U.S. operations to a new office tower being constructed in Chicago where we will lease approximately 235,000 square feet of office space. We also lease approximately 162,000 square feet of office space in 17 countries around the world. We believe that our existing and planned office facilities are adequate for our needs and that additional or substitute space is available to accommodate growth and expansion.

 

Item 3. Legal Proceedings

 

Morningstar Australia

 

In 2001, Mr. Graham Rich, the then managing director and chief executive officer of Morningstar Research Pty Limited (Morningstar Australia), and one of two companies controlled by Mr. Rich, filed a suit in the Supreme Court of New South Wales, Australia against Morningstar and certain of its officers and nominee directors on the board of Morningstar Australia. Mr. Rich was also a beneficial owner of shares in Morningstar Australia. Mr. Rich and his company originally sought an injunction which, if granted, would have precluded Morningstar Australia from terminating the services of Mr. Rich and from issuing additional shares to Morningstar in exchange for the provision of further funding by Morningstar to Morningstar Australia. Further, Mr. Rich and his company sought an order that a provisional liquidator be appointed for Morningstar Australia. The court rejected this injunction application. The application for the appointment of a provisional liquidator also failed. The services of Mr. Rich were terminated in November 2001.

 

Mr. Rich and the two companies controlled by Mr. Rich thereafter filed additional claims, alleging among other things, breaches by Morningstar of contracts and statutory and general law duties, misleading, deceptive, and unconscionable conduct by Morningstar, oppression by Morningstar and its nominee directors, claims under the Industrial Relations Act of New South Wales, breaches of directors’ duties by Morningstar’s nominee directors, and conflict of interest. The claims sought various forms of relief, including monetary damages in the amount of Australian $25,000,000, the setting aside of transactions which resulted in Morningstar obtaining control of Morningstar Australia, and an order either setting aside Morningstar’s acquisition of the shares formerly beneficially owned by Mr. Rich and his companies or determining a different price for this acquisition. In the alternative, Mr. Rich and his companies sought an order that they be entitled to purchase the shares in Morningstar Australia at a price to be determined by the court or book value (as defined in the Morningstar Australia shareholders agreement). Morningstar denied the claims and filed counter-claims against Mr. Rich and certain of his companies, alleging breaches of statutory, general law, and contractual duties.

 

In May 2005, Mr. Rich obtained conditional leave of the court to begin a proceeding in the name of Morningstar Australia against Morningstar and its nominee directors.

 

In the fourth quarter of 2003, Morningstar offered to settle all claims for Australian $1,250,000, which then approximated U.S. $942,000, and, in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, Morningstar recorded a reserve in this amount. In December 2005, Morningstar increased its offer to settle all claims to approximately Australian $2,500,000 (which then approximated U.S. $1,800,000) and in accordance with SFAS No. 5, Morningstar had a reserve recorded in this amount.

 

In August 2007, the parties agreed to a settlement pursuant to which the parties dismissed and released all claims in the proceedings and Morningstar paid Australian $4,000,000 (approximately U.S. $3,300,000) at the date of settlement.  This amount was higher than the previously recorded reserve of Australian $2,500,000 (approximately U.S. $2,100,000 at the settlement date).  We recorded about $900,000 of the difference as legal expense. We accounted for the remainder as an adjustment to the goodwill we initially recorded when we acquired Morningstar Australia in 2001.

 

31



 

Morningstar Associates, LLC Subpoenas from Securities and Exchange Commission, New York Attorney General’s Office, and the Department of Labor

 

Securities and Exchange Commission

 

In February 2005, Morningstar Associates, LLC, a wholly owned subsidiary of Morningstar, Inc., received a request from the SEC for the voluntary production of documents relating to the investment consulting services the company offers to retirement plan providers, including fund lineup recommendations for retirement plan sponsors. In July 2005, the SEC issued a subpoena to Morningstar Associates that was virtually identical to its February 2005 request.

 

Subsequently, the SEC focused on disclosure relating to an optional service offered to retirement plan sponsors (employers) that select 401(k) plan services from ING, one of Morningstar Associates’ clients. In response to the SEC investigation, ING and Morningstar Associates revised certain documents for plan sponsors to further clarify the roles of ING and Morningstar Associates in providing that service. The revisions also help reinforce that Morningstar Associates makes its selections only from funds available within ING’s various retirement products.

 

In January 2007, the SEC notified Morningstar Associates that it ended its investigation, with no enforcement action, fines, or penalties.

 

New York Attorney General’s Office

 

In December 2004, Morningstar Associates received a subpoena from the New York Attorney General’s office seeking information and documents related to an investigation the New York Attorney General’s office is conducting. The request is similar in scope to the SEC subpoena described above. Morningstar Associates has provided the requested information and documents.

 

In January 2007, Morningstar Associates received a Notice of Proposed Litigation from the New York Attorney General’s office. The Notice centers on the same issues that became the focus of the SEC investigation described above. The Notice gave Morningstar Associates the opportunity to explain why the New York Attorney General’s office should not institute proceedings. Morningstar Associates promptly submitted its explanation and has cooperated fully with the New York Attorney General’s office.

 

We cannot predict the scope, timing, or outcome of this matter, which may include the institution of administrative, civil, injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key employees, and the loss of customers. We also cannot predict what impact, if any, this matter may have on our business, operating results, or financial condition.

 

United States Department of Labor

 

In May 2005, Morningstar Associates received a subpoena from the United States Department of Labor, seeking information and documents related to an investigation the Department of Labor is conducting. The Department of Labor subpoena is substantially similar in scope to the SEC and New York Attorney General subpoenas.

 

In January 2007, the Department of Labor issued a request for additional documents pursuant to the May 2005 subpoena, including documents and information regarding Morningstar Associates’ retirement advice products for plan participants. Morningstar Associates continues to cooperate fully with the Department of Labor.

 

We cannot predict the scope, timing, or outcome of this matter, which may include the institution of administrative, civil, injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key employees, and the loss of customers. We also cannot predict what impact, if any, these matters may have on our business, operating results, or financial condition.

 

32



 

In addition to these proceedings, we are involved in legal proceedings and litigation that have arisen in the normal course of our business. Although the outcome of a particular proceeding can never be predicted, we do not believe that the result of any of these matters will have a material adverse effect on our business, operating results, or financial condition.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of our security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 2007.

 

Part II

 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

 

Our common stock is listed on the Nasdaq Global Select Market under the symbol “MORN.”

 

The following table shows the high and low price per share of our common stock for the periods indicated, as reported on the Nasdaq Global Select Market:

 

 

 

2007

 

2006

 

 

 

High

 

Low

 

High

 

Low

 

 

 

 

 

 

 

 

 

 

 

First Quarter

 

$

54.57

 

$

44.60

 

$

46.37

 

$

33.79

 

 

 

 

 

 

 

 

 

 

 

Second Quarter

 

54.72

 

46.10

 

47.56

 

35.66

 

 

 

 

 

 

 

 

 

 

 

Third Quarter

 

67.16

 

46.48

 

42.76

 

32.99

 

 

 

 

 

 

 

 

 

 

 

Fourth Quarter

 

85.50

 

61.50

 

47.36

 

36.32

 

 

As of February 29, 2008, the last reported price on the Nasdaq Global Select Market for our common stock was $65.19 per share and there were approximately 775 shareholders of record of our common stock.

 

We do not currently pay cash dividends, nor have we paid cash dividends during the period covered by the financial statements included in this Annual Report on Form 10-K. Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law, and other factors deemed relevant by the board of directors. Future indebtedness and loan facilities may also prohibit or restrict our ability to pay dividends and make distributions to our shareholders.

 

Rule 10b5-1 Plans

 

Our directors and executive officers may exercise stock options or purchase or sell shares of our common stock in the market from time to time. We encourage them to make these transactions through plans that comply with Exchange Act Rule 10b5-1(c). Morningstar will not receive any proceeds, other than proceeds from the exercise of stock options, related to these transactions.

 

33



 

The following table, which we are providing on a voluntary basis, shows the Rule 10b5-1 sales plans entered into by our directors and executive officers that were in effect as of March 1, 2008:

 

Name and Position

 

Date of
Plan

 

Plan
Termination
Date

 

Number of
Shares
to be
Sold under
the Plan

 

Timing of Sales under the Plan

 

Number of
Shares
Sold under
the Plan through
March 1,
2008

 

Projected
Beneficial
Ownership(1)

Joe Mansueto

Chairman and

Chief Executive

Officer

 

09/12/07

 

12/31/08

 

1,120,000

 

Shares to be sold ratably over the course of the plan

 

216,842

 

26,976,550

Cheryl Francis

Director

 

09/12/07

 

12/14/08

 

20,000

 

Daily increments of up to 500 shares, or all remaining shares under the plan if the stock reaches a specified price

 

1,500

 

32,824

Tao Huang

Chief Operating

Officer

 

02/26/08

 

12/31/08

 

300,000

 

Weekly increments of up to 10,000 shares beginning March 26, 2008

 

 

1,090,303

Jack Noonan

Director

 

08/22/06

 

12/31/08

 

72,000

 

Monthly increments of up to 1,000 shares

 

62,000

 

68,824

Don Phillips

Managing Director

 

05/09/06

 

11/30/08

 

1,382,310

 

Weekly increments of up to 17,500 shares

 

711,600

 

541,196

Richard Robbins

General Counsel

and Corporate

Secretary

 

12/19/07

 

07/31/08

 

5,000

 

Biweekly increments of up to 500 shares

 

 

11,078

Paul Sturm

Director

 

03/21/07

 

04/30/08

 

120,000

 

Biweekly increments of up to 5,000 shares

 

115,000

 

235,824

 


(1)   This column reflects an estimate of the number of shares each identified director and executive officer will beneficially own following the sale of all shares under the Rule 10b5-1 sales plans identified above. This information reflects the beneficial ownership of our common stock on December 31, 2007, and includes shares of our common stock subject to options that were then exercisable or that will have become exercisable by February 29, 2008 and restricted stock units that will vest by February 29, 2008.  The estimates do not reflect any changes to beneficial ownership that may have occurred since December 31, 2007.  Each director and executive officer identified in the table may amend or terminate his or her Rule 10b5-1 sales plan and may adopt additional Rule 10b5-1 plans in the future.

 

34



 

Item 6. Selected Financial Data

 

The selected historical financial data shown below should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and related notes included elsewhere in this Annual Report on Form 10-K. We have derived our Consolidated Statements of Operations Data and Other Consolidated Financial Data for the years ended December 31, 2007, 2006, and 2005 and Consolidated Balance Sheet Data as of December 31, 2007 and 2006 from our audited Consolidated Financial Statements included in this Annual Report on Form 10-K. The Consolidated Statements of Operations Data and Other Consolidated Financial Data for the years ended December 31, 2004 and 2003 and Consolidated Balance Sheet Data as of December 31, 2005, 2004, and 2003 were derived from our audited Consolidated Financial Statements that are not included in this Annual Report on Form 10-K.

 

Consolidated Statements of Operations Data

(in thousands except per share amounts)

 

2003

 

2004

 

2005

 

2006

 

2007

 

Revenue

 

$

139,496

 

$

179,658

 

$

227,114

 

$

315,175

 

$

435,107

 

Operating expense

 

150,250

 

161,923

 

180,634

 

237,648

 

317,853

 

Operating income (loss)

 

(10,754

)

17,735

 

46,480

 

77,527

 

117,254

 

Non-operating income, net

 

1,110

 

1,805

 

3,199

 

4,164

 

6,229

 

Income (loss) before income taxes, equity in net income of unconsolidated entities, and cumulative effect of accounting change

 

(9,644

)

19,540

 

49,679

 

81,691

 

123,483

 

Income tax expense

 

2,950

 

11,574

 

20,224

 

32,975

 

51,255

 

Equity in net income of unconsolidated entities

 

697

 

843

 

1,662

 

2,787

 

1,694

 

Income (loss) before cumulative effect of accounting change

 

(11,897

)

8,809

 

31,117

 

51,503

 

73,922

 

Cumulative effect of accounting change, net of tax of $171

 

 

 

 

259

 

 

Net income (loss)

 

$

(11,897

)

$

8,809

 

$

31,117

 

$

51,762

 

$

73,922

 

Basic income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

Basic income (loss) per share before cumulative effect of accounting change

 

$

(0.31

)

$

0.23

 

$

0.79

 

$

1.25

 

$

1.71

 

Cumulative per share effect of accounting change

 

 

 

 

0.01

 

 

Basic net income (loss) per share

 

$

(0.31

)

$

0.23

 

$

0.79

 

$

1.26

 

$

1.71

 

Weighted average common shares outstanding—basic

 

38,382

 

38,418

 

39,392

 

41,176

 

43,216

 

Diluted income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

Diluted income (loss) per share before cumulative effect of accounting change

 

$

(0.31

)

$

0.21

 

$

0.70

 

$

1.10

 

$

1.53

 

Cumulative per share effect of accounting change

 

 

 

 

0.01

 

 

Diluted net income (loss) per share

 

$

(0.31

)

$

0.21

 

$

0.70

 

$

1.11

 

$

1.53

 

Weighted average common shares outstanding—diluted

 

38,382

 

41,858

 

44,459

 

46,723

 

48,165

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Consolidated Financial Data ($000)

 

2003

 

2004

 

2005

 

2006

 

2007

 

Stock-based compensation expense under the liability method

 

$

17,796

 

$

8,963

 

$

2,810

 

$

 

$

 

Stock-based compensation expense under the equity method

 

11,233

 

7,760

 

8,085

 

8,575

 

10,978

 

Total stock-based compensation expense (1)

 

$

29,029

 

$

16,723

 

$

10,895

 

$

8,575

 

$

10,978

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales tax expense (2)

 

$

3,079

 

$

 

$

 

$

 

$

 

Cash used for investing activities (3)

 

(29,634

)

(22,750

)

(16,913

)

(129,002

)

(102,838

)

Cash provided by (used for) financing activities (4) (8)

 

(26

)

(6,367

)

25,256

 

33,983

 

52,465

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

29,705

 

$

32,862

 

$

48,445

 

$

98,677

 

$

112,368

 

Capital expenditures

 

(8,607

)

(7,730

)

(7,451

)

(4,722

)

(11,346

)

Free cash flow (5)

 

$

21,098

 

$

25,132

 

$

40,994

 

$

93,955

 

$

101,022

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheet Data
As of December 31 ($000)

 

2003

 

2004

 

2005

 

2006

 

2007

 

Cash, cash equivalents and investments

 

$

76,158

 

$

95,463

 

$

153,190

 

$

163,751

 

$

258,588

 

Working capital (deficit) (6)

 

(5,206

)

16,902

 

90,374

 

70,021

 

149,723

 

Total assets

 

180,265

 

213,361

 

296,311

 

447,838

 

649,307

 

Deferred revenue (6)

 

55,554

 

63,363

 

71,155

 

100,525

 

129,302

 

Long-term liabilities (7)

 

25,486

 

30,128

 

6,756

 

10,952

 

23,166

 

Total shareholders’ equity (7) (8)

 

44,821

 

64,381

 

173,714

 

269,423

 

408,303

 

 

35



 


(1)

 

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)). Prior to this date, we accounted for our equity plans in accordance with the fair value provisions of SFAS No. 123, Stock-based Compensation. The total expense for stock-based compensation is distributed with other employee compensation costs in the appropriate operating expense categories of our Consolidated Statements of Operations. Prior to our initial public offering in May 2005, in accordance with SFAS No. 123, we used two accounting methods. For options granted under plans that may have required us to settle the options in cash, we used the liability method. Under this method we recorded a liability for a vested option equal to the difference between the option exercise price and the fair value of the shares of common stock underlying the option at the end of the reporting period. If this fair value increased over the reporting period, we recorded an expense and, if it decreased, we recorded income. For options granted under plans that did not require us to settle the options in cash, we used the equity method. Under this method we calculated the fair value of the option at the time of grant using a Black-Scholes model and recorded expense over the vesting period. In each year, our aggregate stock-based compensation expense reflects the impact of options granted in prior years. Subsequent to our initial public offering, we no longer settle stock options for cash. As a result, all of our options are currently accounted for under the equity method.

 

 

 

 

 

In 2006, we began granting restricted stock units. We measure the fair value of our restricted stock units on the date of grant based on the market price of the underlying common stock as of the close of trading on the day prior to grant. We amortize that value to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period. Refer to Note 11 of the Notes to our Consolidated Financial Statements for more information on our stock-based compensation.

 

 

 

(2)

 

In 2003, we began participating in voluntary disclosure or similar programs related to state sales tax. Through these programs, we identified sales tax amounts attributed to 2003 and prior years and negotiated or are in discussions with local tax authorities to settle these amounts. We recorded total expense of $9.0 million in 2000, 2001, 2002, and 2003, the years to which these sales tax amounts apply. Based on the most current information available, the actual sales tax expense was not materially different from the estimates recorded in those periods.

 

 

 

(3)

 

Cash used for investing activities consists primarily of cash used for acquisitions; purchases of investments, net of proceeds from the sale of investments; and capital expenditures. The level of investing activities can vary from period to period depending on the level of activity in these three categories. Cash used for investing activities increased substantially in 2007 and 2006, primarily for acquisitions. Over the past two years, Morningstar made four key acquisitions. In addition, capital expenditures increased in 2007 compared with prior years’ spending levels. Refer to Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources, for more information concerning cash used for investing activities.

 

36



 

(4)

 

Cash provided by financing activities in 2005 includes $18.1 million of net proceeds from our initial public offering in May 2005. In 2006 and 2007, cash provided by financing activities consists primarily of proceeds from stock option exercises and excess tax benefits. Refer to Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources, for more information concerning cash provided by financing activities.

 

 

 

(5)

 

Free cash flow is considered a non-GAAP financial measure under SEC regulations. We present this measure as supplemental information to help investors better understand trends in our business results over time. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not equivalent to any measure of performance required to be reported under U.S. generally accepted accounting principles (U.S. GAAP), nor should this data be considered an indicator of our overall financial performance or liquidity. Moreover, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

 

 

 

(6)

 

We frequently invoice or collect cash in advance of providing services or fulfilling subscriptions for our customers. These amounts are recorded as deferred revenue on our Consolidated Balance Sheets. As a result of recording deferred revenue, our working capital may at times be negative.

 

 

 

(7)

 

In the second quarter of 2005, upon completion of our initial public offering, we reclassified $24.9 million related to stock options accounted for as long-term liabilities, in accordance with SFAS No. 123, to additional paid-in capital.

 

 

 

(8)

 

In May 2005, we completed our initial public offering of 7,612,500 shares of our common stock. These shares commenced trading on May 3, 2005 and now trade on the Nasdaq Global Select Market under the symbol “MORN.” All of these shares were sold by affiliates of SOFTBANK Finance Corporation, a wholly owned subsidiary of SOFTBANK Corp. We did not receive any proceeds from the sale of these shares. In addition, we granted the underwriters the right to purchase up to an additional 1,141,875 shares at the initial public offering price to cover over-allotments. In May 2005, the underwriters exercised their over-allotment option in full. We received net proceeds of $18.1 million based on our initial public offering price of $18.50 per share, after deducting the underwriting discounts and commissions and approximately $2.6 million of offering expenses.

 

37



 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The discussion included in this section, as well as other sections of this Annual Report on Form 10-K, contains forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995. These statements are based on our current expectations about future events or future financial performance. Forward-looking statements by their nature address matters that are, to different degrees, uncertain, and often contain words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue.” These statements involve known and unknown risks and uncertainties that may cause the events we discussed not to occur or to differ significantly from what we expected. For us, these risks and uncertainties include, among others, general industry conditions and competition; damage to our reputation resulting from claims made about possible conflicts of interest; liability for any losses that result from an actual or claimed breach of our fiduciary duties; legal, regulatory, or political issues related to our data center in China; the potential impact of market volatility on revenue from asset-based fees; a prolonged outage of our database and network facilities; challenges faced by our non-U.S. operations; and the availability of free or low-cost investment information.

 

A more complete description of these risks and uncertainties can be found in Item 1A — Risk Factors of this Annual Report on Form 10-K. If any of these risks and uncertainties materialize, our actual future results may vary significantly from what we projected. We do not undertake to update our forward-looking statements as a result of new information or future events.

 

Understanding Our Company

 

Our mission is to create great products that help investors reach their financial goals. We offer an extensive line of Internet, software, and print-based products for individual investors, financial advisors, and institutional clients. We also offer asset management services for advisors, institutions, and retirement plan participants. Many of our products are sold through subscriptions or license agreements. As a result, we typically generate recurring revenue.

 

We emphasize a decentralized approach to running our business to empower our managers and to create a culture of responsibility and accountability. We operate our business in three global segments: Individual, Advisor, and Institutional. In all three of these segments, we believe our work helps individual investors make better investment decisions.

 

Historically, we have focused primarily on organic growth by introducing new products and services and expanding our marketing efforts for existing products. However, we have made and expect to continue making selective acquisitions that support our four key growth strategies, which are:

 

·                  Enhance our position in each of our three operating segments by focusing on our three major Internet-based platforms;

·                  Become a global leader in funds-of-funds investment management;

·                  Expand the range of services we offer investors, financial advisors, and institutional clients; and

·                  Expand our international brand presence, products, and services.

 

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39



 

Key Business Characteristics

 

Revenue

 

We generate revenue by selling a variety of investment-related products and services. We sell many of our offerings, such as our newsletters, Principia software, and Premium service on Morningstar.com, via subscriptions. These subscriptions are mainly offered for a one-year term, although we also offer terms ranging from one month to three years. We also sell advertising on our Web sites throughout the world. Several of our other products are sold through license agreements, including Morningstar Advisor Workstation, Morningstar Equity Research, Morningstar Direct, Morningstar EnCorr, Retirement Advice, and Licensed Data. Our license agreements typically range from one to three years. For some of our other institutional services, mainly Investment Consulting, we generally base our fees on the scope of work and the level of service we provide and calculate them as a percentage of assets under management. We also earn fees relating to Morningstar Managed Portfolios and the managed retirement accounts offered through Morningstar Retirement Manager and Advice by Ibbotson that we calculate as a percentage of assets under management. Overall, revenue tied to asset-based fees accounted for about 16% of our consolidated revenue in 2007.

 

Deferred Revenue

 

We frequently invoice our clients and collect cash in advance of providing services or fulfilling subscriptions for our customers. As a result, we use some of this cash to fund our operations and invest in new product development. The businesses we acquired in 2007 and 2006 have similar business models, and as a result, we acquired their deferred revenue.  The deferred revenue shown on our balance sheet totaled $129.3 million as of December 31, 2007 and $100.5 million as of December 31, 2006.  Deferred revenue is the largest liability on our Consolidated Balance Sheets.  We expect to recognize the deferred revenue in future periods as we fulfill our service obligations under our subscription, license, and service agreements.

 

Significant Operating Leverage

 

Our business requires significant investments to create and maintain proprietary databases and content. We strive to leverage these costs by selling a wide variety of products and services to multiple investor segments, through multiple media, and in many geographic markets. We believe that while the fixed costs of the investments in our business are relatively high, the variable cost of adding customers is considerably lower, particularly as our products and services focus more on Internet-based platforms and assets under management. In the past, we have made investments in building our databases and content that have hurt our short-term operating results for certain periods. In the past several years, our profitability has improved because we’ve been able to increase revenue without increasing our cost base at the same rate. We look for this operating leverage to be evident in our operations over the long term.

 

Operating Expense

 

We classify our expenses into separate categories for cost of goods sold, development, sales and marketing, general and administrative, and depreciation and amortization, as described below. We include stock-based compensation expense, as appropriate, in each of these categories.

 

·      Cost of goods sold. This category includes the compensation expense for employees who produce the products we deliver to our customers. For example, this category covers the cost of production teams and analysts who write investment research reports. Cost of goods sold also includes other expenses such as postage, printing, and CD-ROM replication, as well as shareholder servicing fees for Morningstar Managed Portfolios.

 

·      Development. This category mainly includes compensation expense for programmers, designers, and other employees who develop new products and enhance existing products. In some cases, we capitalize the compensation costs associated with certain development projects. This reduces the expense that we would otherwise report in this category. We amortize these capitalized costs over the estimated economic life of the software, which is generally three years, and include this expense in depreciation and amortization.

 

40



 

·      Sales and marketing. This category includes compensation expense for our sales teams, product managers, and other marketing professionals. We also include the cost of advertising, direct mail campaigns, and other marketing programs to promote our products.

 

·      General and administrative. This category consists mainly of compensation expense for each segment’s management team, as well as human resources, finance, and support employees for each segment. The category also includes compensation expense for senior management and corporate expenses, including corporate systems, accounting, legal, and facilities expense.

 

·      Depreciation and amortization. Our capital expenditures consist mainly of computers, leasehold improvements, and capitalized product development costs related to certain software development projects. We depreciate property and equipment primarily using the straight-line method based on the useful life of the asset, which ranges from three to seven years. We amortize leasehold improvements over the remaining lease term or their useful lives, whichever is shorter. We amortize capitalized product development costs over their estimated economic life, which is generally three years. We also include amortization related to intangible assets, which is mainly driven by acquisitions, in this category.

 

International Operations

 

We consolidate the results of our majority-owned operations outside the United States. We account for our minority-owned investments in Japan, Korea, Denmark, and Sweden using the equity method.

 

Our international operations continue to become a more important part of our business. Our non-U.S. revenue increased to 20.6% of consolidated revenue in 2007—6.6 percentage points higher than in 2006.

 

How We Evaluate Our Business

 

When our analysts evaluate a stock, they focus on assessing the company’s estimated intrinsic value—the value of the company’s future cash flows, discounted to their worth in today’s dollars. Our approach to evaluating our own business works the same way. Our goal is to increase the intrinsic value of our business over time, which we believe is the best way to create value for our shareholders.

 

We do not make public financial forecasts for our business because they are, by their nature, subjective and could have an effect on our company’s stock price. We want to avoid creating any incentives for people within our company to make speculative statements about our financial results that could influence the stock price, or to take actions that help us meet short-term forecasts but may not be in the long-term interest of building shareholder value.

 

We provide three specific measures that can help investors generate their own assessment of how our intrinsic value has changed over time:

 

·                  Revenue;

 

·                  Operating income (loss); and

 

·                  Free cash flow, which we define as cash provided by or used for operating activities less capital expenditures.

 

Free cash flow is considered a non-GAAP financial measure under Securities and Exchange Commission (SEC) regulations. We present this measure as supplemental information to help investors better understand trends in our business results over time. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not equivalent to any measure of performance required to be reported under U.S. generally accepted accounting principles (U.S. GAAP), and should not be considered an indicator of our overall financial performance or liquidity. Moreover, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

 

41



 

To evaluate how successful we’ve been in maintaining existing business for products and services that have renewable revenue, we calculate a retention rate. We use two different methods for calculating retention. For subscription-based products (including our print newsletters, Morningstar.com Premium Membership service, and Principia software), we track the number of subscriptions retained during the year. For products sold through contracts and licenses, we use the contract value method, which is based on tracking the dollar value of renewals compared with the total dollar value of contracts up for renewal during the period. We include changes in the contract value in the renewal amount, unless the change specifically results from adding a new product that we can identify. We also include variable contracts in this calculation and use the previous quarter’s actual revenue as the base rate for calculating the renewal percentage. The retention rate excludes setup and customization fees, migrations to other Morningstar products, and contract renewals that were pending as of January 31, 2008.

 

The Year 2007 in Review

 

Industry Overview

 

We monitor developments in the economic and financial information industry on an ongoing basis. We use these insights to help inform our company strategy, product development plans, and marketing initiatives.

 

Investment Landscape, Research, and Data

 

Despite pronounced market volatility and a market downturn during the fourth quarter of 2007, the U.S. equity markets finished the year in positive territory. Morningstar’s U.S. Market Index, a broad market benchmark, ended the year with a 5.9% total return, compared with 15.7% in 2006. Most markets outside of the United States finished the year with higher total returns versus the U.S. Market Index.

 

The crisis in subprime mortgages caused extreme disruption in the financial markets beginning in late 2007. We believe that the impact of these problems in the financial services sector to date has been the most severe in areas such as mortgage lending, commercial banking, and investment banking, with less direct impact on asset management firms. However, there could be a spillover effect on other areas as the financial services sector attempts to address issues relating to the subprime mortgage crisis, uncertain credit markets, and a slowing economy.

 

Total U.S. mutual fund assets increased to $12.0 trillion as of December 31, 2007 based on data from the Investment Company Institute (ICI), compared with $10.4 trillion as of December 31, 2006. Net new cash flows into hybrid funds and taxable bond funds increased over 2006 levels, but cash flows into equity funds were substantially lower. The number of mutual funds declined slightly to 8,000 during 2007, compared with about 8,100 the previous year.

 

The Investment Company Institute estimates that about 51 million households in the United States, or 44% of all households, own mutual funds. This total is down slightly from its peak in 2001, but consistent with the levels shown over the past several years.

 

We believe continued asset growth and widespread usage of mutual funds is significant because a relatively large portion of Morningstar’s business has historically focused on this area. However, this percentage has been declining as we’ve expanded into equity research and other areas.

 

Interest in alternative asset classes, such as hedge funds, remained strong during most of 2007. Based on data from Hedge Fund Research, which tracks asset flows into hedge funds, hedge funds had about $195 billion in net inflows during 2007, compared with $127 billion in net inflows in 2006. Hedge Fund Research estimates that total hedge fund industry assets increased to $1.87 trillion as of December 2007, a 30% increase from year-end 2006.

 

42



 

Based on data from Cerulli Associates, assets invested in separate accounts reached $850 billion as of December 31, 2007, up from about $767 billion as of year-end 2006. Based on Morningstar’s data, we estimate that total assets invested in variable annuities totaled about $1.5 trillion as of December 31, 2007.

 

Assets in exchange-traded funds (ETFs) increased about 44% to reach about $608 billion as of December 2007, compared with $423 billion as of December 2006, based on data from the ICI. During 2007, the number of U.S.-based ETFs increased to more than 600, compared with about 350 previously. ETFs have gained share from mutual funds in some areas of the market and have also started being used in defined contribution plans, such as 401(k)s. To meet greater investor demand for information on ETFs, we have continued to increase analyst coverage in this area and now cover about 165 ETFs. We’re also planning to create a new cover page for the ETF area of Morningstar.com and recently introduced a new report format for ETFs.

 

In 2007, we also saw significant investor interest and new product development in open-end mutual funds that pursue alternative investment strategies, such as 130/30 funds, which invest in traditional long-only securities but also sell short a portion of their assets and use the proceeds to build additional long exposure. We believe this trend signifies that the lines are blurring between traditional mutual funds registered under the Investment Company Act and alternative investment strategies often used by hedge funds. We believe we’re well-positioned to meet the need for information and analysis on complex investment strategies, and that our broad investment coverage also gives us an advantage in meeting this market need.

 

Individual Investor Market

 

Based on research from Nielsen/NetRatings, total page views to retail investment Web sites decreased in the fourth quarter of 2007, with aggregate page views declining 2% from the same period in 2006. However, some sites showed large increases and others posted declines. Overall, the number of unique users to retail investment Web sites increased by about 17%. For Morningstar.com, both page views and unique users increased in the fourth quarter of 2007 from the same period in 2006. Morningstar.com continued to perform better than competing sites based on metrics such as time spent per visit and the number of pages viewed per visit.

 

Financial Advisor Market

 

In 2007, demand for financial advisory services continued to rise, as an increasing percentage of investors have been working with advisors to plan their financial futures. The independent advisor channel has had particularly strong growth over the past three years, based on research published by Financial Research Corporation. We believe this trend is important because our products are well-suited to meet the needs of the independent financial advisors, and we have a strong market position in this growing area.

 

Larger advisory firms have been continuing to prepare for the pending termination of the “Merrill Lynch rule,” which allowed brokerage firms to provide investment advice in exchange for an asset-based fee. We think this development is notable because we believe many broker-dealers may shift their clients out of fee-based brokerage accounts, which typically include various services, including investment advice, in exchange for an asset-based fee. We believe this highlights the ongoing regulatory complexity in the advisor segment. In addition, it may lead to additional business opportunities for the investment advisory services we offer.

 

Institutional Market

 

In the United States, there has been continuing debate about improving disclosure of fees and returns in 401(k) plans. In July 2007, the U.S. House Education and Labor Committee chairman submitted a bill that would require 401(k) plans to disclose more information to retirement plan participants each year, as well as provide for additional oversight by the Department of Labor. We believe this development is important because it highlights the need for transparency in the retirement market.

 

43



 

The Pension Protection Act of 2006 has led to more use of target-date funds and other qualified default investment alternatives. In addition, the Pension Protection Act has led to more opportunities for retirement advice programs offered at the employer level. We continue to expand our retirement advice offerings to meet this need, particularly in managed retirement accounts.

 

Merger and acquisition activity continued in the industry in 2007. In May 2007, Thomson Corporation and Reuters entered into an agreement to form a combined company, Thomson-Reuters. Pending regulatory approval, the two companies expect to complete the merger in the second quarter of 2008. We continue to monitor merger and acquisition activity in our industry because of its potential impact on our business.

 

As an industry-wide trend, we continued to see strong interest in retirement income in 2007. A large number of investors are currently approaching retirement and making the transition from accumulating assets to drawing down their portfolios. As a result, Financial Research Corporation estimates that total assets invested in retirement income related products will total more than $7 trillion over the next 10 or 15 years. We have continued to develop products and services to meet this need, including target spending portfolios, annuitization programs, and retirement income planning tools.

 

Worldwide Markets

 

In Europe, many financial services companies have been preparing for the upcoming implementation date of the Market in Financial Instruments Directive (MiFID). The directive took effect in November 2007 and obligates companies to be more transparent with clients and make efforts to provide better-quality service to investors. We believe Morningstar is well-positioned to help companies meet the new requirements because our services and products are already largely in line with MiFID’s objectives.

 

In Germany, the legislature recently passed a tax rule that involves taxing long-term capital gains of mutual funds starting in January 2009. Investors holding funds of funds, however, will have some tax protection until they sell the fund. In addition, insurance-wrapped funds will be subject to different taxation rules that are more favorable than direct fund investments. Because of this change, we expect continued asset growth and product launches in insurance-wrapped and funds-of-of funds products.

 

In Canada, the traditional pension fund area continues to expand. We believe that pension funds have a need for more information on the various asset classes they invest in and see opportunities for Morningstar to add value in this area. In addition, Canadian regulators recently increased the age limits and annual contribution limits for several types of savings plans.

 

In New Zealand, the government introduced a new Kiwi Saver retirement savings initiative in July 2007 and established a number of incentives, including government and compulsory employer contributions, that will start in April 2008.

 

In Japan, regulators implemented a new Financial Products Law in September 2007. The new law entails more risk disclosure and suitability requirements, which we think is positive for the industry.

 

Emerging markets across Asia continued their strong growth in 2007, and we’ve continued to expand our presence to meet the need for investment information in markets such as China and India. We are expanding our operations in India and plan to launch a Web site for individual investors in 2008.

 

44



 

Performance Summary

 

The list below summarizes the key accomplishments and challenges that our management team has highlighted related to our 2007 performance:

 

·                  We significantly increased our global presence. We doubled our revenue outside the United States and expanded our global database to 265,000 investment vehicles. Part of this growth came from the fund data business acquired from Standard & Poor’s, which strengthened our brand in several international markets. The integration was a big undertaking, and we accomplished it swiftly. In December 2007, we announced our plans to acquire several Hemscott businesses. We completed that acquisition on January 9, 2008.

 

·                  Our Investment Consulting businesses—both Ibbotson Associates and Morningstar Associates—had a banner year, contributing about 24% of our annual revenue growth. We now have $97.5 billion in assets under advisement. Revenue from asset-based fees now makes up approximately 16% of our consolidated revenue. Despite significant market volatility, we continued to see net inflows into the funds of funds on which we provide advisory services throughout most of 2007. However, our asset-based revenue could be affected by a decline in the equity market.

 

·                  We launched a host of new offerings, including Morningstar Site Builder, which allows investment firms to integrate our tools and content into their Web sites; Advisor Workstation Office Edition in the UK; Morningstar Advisor Magazine; and a family of fixed-income and commodity futures indexes.

 

·                  We continued to invest in our analyst staff and now have 171 stock and fund analysts around the world. We began qualitative research coverage on open-end investment companies and unit trusts in the UK and initial public offerings in the United States.

 

·                  We strengthened our board with the addition of two new members, Frank Ptak, president and CEO of the Marmon Group, and William Lyons, former president and CEO of American Century Companies.

 

·                  We launched a Retirement Income Strategist tool for financial advisors in late 2006, but did not see strong demand in 2007. We believe there’s a growing need for solutions that help investors manage their income during retirement, and we’ve also developed several services for institutional clients within our Investment Consulting areas. We expect our in-retirement solutions to gain greater adoption in 2008.

 

Consolidated Results

 

($000)

 

2007

 

2006

 

2005

 

2007 Change

 

2006 Change

 

Revenue

 

$

435,107

 

$

315,175

 

$

227,114

 

38.1%

 

38.8%

 

Operating income

 

117,254

 

77,527

 

46,480

 

51.2%

 

66.8%

 

Operating margin

 

26.9%

 

24.6%

 

20.5%

 

2.3pp

 

4.1pp

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash used for investing activities

 

$

(102,838)

 

$

(129,002)

 

$

(16,913)

 

(20.3)%

 

662.7%

 

Cash provided by financing activities

 

52,465

 

33,983

 

25,256

 

54.4%

 

34.6%

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

112,368

 

$

98,677

 

$

48,445

 

13.9%

 

103.7%

 

Capital expenditures

 

(11,346)

 

(4,722)

 

(7,451)

 

140.3%

 

(36.6)%

 

Free cash flow

 

$

101,022

 

$

93,955

 

$

40,994

 

7.5%

 

129.2%

 

 

 

 

 

 

 

 

 

 

 

 

 

NMF—not meaningful

pp—percentage point(s)

 

As noted in How We Evaluate Our Business, we define free cash flow as cash provided by or used for operating activities less capital expenditures. We present free cash flow as a supplemental disclosure to help you better understand how much cash is available after we spend money to operate our business. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not a measure of performance set forth under U.S. generally accepted accounting principles (GAAP). Also, the free cash flow definition we use may not be comparable to similarly titled measures used by other companies.

 

45



 

Because we’ve made several acquisitions in recent years, comparing our financial results from year to year is complex. To make it easier for investors to compare our results in different periods, we provide information on both organic revenue, which includes our underlying business excluding acquisitions, and revenue from acquisitions. We include an acquired operation as part of our revenue from acquisitions for 12 months after we complete the acquisition. After that, we include it as part of our organic revenue stream.

 

The table below shows the periods in 2006 and 2007 during which we included each acquired operation in revenue from acquisitions:

Acquisition

 

2006

 

2007

Ibbotson Associates, Inc.

 

March 1 through December 31, 2006

 

January 1 through February 28, 2007

 

 

 

 

 

Aspect Huntley Pty Limited

 

July 25 through December 31, 2006

 

January 1 through July 24, 2007

 

 

 

 

 

Hedge fund and separate account database division of InvestorForce, Inc.

 

August 1 through December 31, 2006

 

January 1 through July 31, 2007

 

 

 

 

 

Mutual fund data business from Standard & Poor’s

 

 

March 16 through December 31, 2007

 

Consolidated Revenue

 

In 2007, our consolidated revenue increased 38.1% to $435.1 million. During 2007, we had strong organic growth as well as new revenue from acquisitions, the majority of which was from the mutual fund data business we acquired from Standard & Poor’s in March 2007. As a whole, acquisitions contributed $44.2 million, or 14 percentage points, to our consolidated revenue growth in 2007—a slightly lower percentage compared with 2006.

 

Our consolidated revenue increased 38.8% to $315.2 million in 2006 from strong organic growth as well as new revenue from three key acquisitions: Ibbotson Associates, Aspect Huntley, and the hedge fund and separate account database division of InvestorForce. Adding these operations to our existing business contributed $36.4 million of revenue, the majority of which was from Ibbotson. These acquisitions represented 16 percentage points of our consolidated revenue growth in 2006.

 

To give investors more insight on our company’s underlying growth rate, we provide information about our organic revenue growth, which excludes revenue from acquisitions and foreign currency translations. On this measure, we also performed well. Organic revenue growth was $71.9 million, or 22.8%, in 2007, which was in line with our performance in 2006.

 

Consolidated revenue excluding acquisitions and the impact of foreign currency translations (organic revenue) is considered a non-GAAP financial measure. The definition of organic revenue we use may not be the same as similarly titled measures used by other companies. Organic revenue should not be considered an alternative to any measure of performance as promulgated under GAAP.

 

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The tables below reconcile consolidated revenue with revenue excluding acquisitions and the impact of foreign currency translations (organic revenue):

 

2007 vs. 2006 ($000)

 

2007

 

2006

 

Change

 

Consolidated revenue

 

$

435,107

 

$

315,175

 

38.1%

 

Less: acquisitions

 

(44,226

)

 

NMF

 

Less: impact of foreign currency translations

 

(3,808

)

 

NMF

 

Revenue excluding acquisitions and the impact of foreign currency translations

 

$

387,073

 

$

315,175

 

22.8%

 

 

2006 vs. 2005 ($000)

 

2006

 

2005

 

Change

 

Consolidated revenue

 

$

315,175

 

$

227,114

 

38.8%

 

Less: acquisitions

 

(36,434

)

 

NMF

 

Less: impact of foreign currency translations

 

(793

)

 

NMF

 

Revenue excluding acquisitions and the impact of foreign currency translations

 

$

277,948

 

$

227,114

 

22.4%

 

 

While organic revenue growth and acquisitions had the most significant impact on revenue in 2007 and 2006, we also enjoyed a benefit from foreign currency translations in each year because of continued weakness in the U.S. dollar.

 

In both 2007 and 2006, our growth was diversified by segment, with all three segments contributing to revenue growth. However, the Institutional segment, which now makes up more than half of our consolidated revenue, generated approximately 70% of our company-wide revenue increase in 2007. Acquisitions contributed $33.4 million to Institutional segment revenue in 2007. The Institutional segment was also the main contributor to the revenue increase in 2006, accounting for about 56% of Morningstar’s total revenue increase before eliminating intersegment revenue. Acquisitions contributed $25.1 million to Institutional segment revenue in 2006.

 

Our two other segments also generated strong revenue growth. Advisor segment revenue rose $21.0 million, or 22.2%, in 2007, accounting for approximately 17% of the revenue increase before eliminating intersegment revenue. Acquisitions contributed $5.8 million to the Advisor segment revenue in 2007. Advisor segment revenue rose approximately 30.3% in 2006 compared with the full year of 2005, with acquisitions contributing $6.2 million of the revenue increase.

 

Individual segment revenue increased $16.6 million, or 20.6%, in 2007 and $17.3 million, or 27.2%, in 2006. Acquisitions contributed approximately $5.1 million to the Individual segment in 2007 and in 2006.

 

GRAPHIC

 

On a product level, Investment Consulting was the largest driver behind our revenue increase in 2007 and 2006. Much of our business in this area focuses on asset allocation services that we provide for funds of funds, where we typically act as a portfolio consultant or portfolio construction manager. We continued to see significant growth in assets under advisement from existing clients in both years. Changes in the value of assets under advisement can come from two primary sources: gains or losses related to overall trends in market performance, and net inflows or outflows caused when investors add to or redeem shares from these portfolios. In both 2006 and 2007, both factors contributed to growth in assets under advisement, but increases in net inflows were the main driver behind the asset growth. In 2007, the majority of the revenue increase was driven by organic revenue growth, which came from both Morningstar Associates and Ibbotson Associates. In 2006, newly added revenue from Ibbotson’s Investment Consulting business generated more than 40% of the revenue growth in this product, with the remaining amount from Morningstar’s existing consulting business.

 

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Advisor Workstation was the second-largest driver of the organic revenue increase in 2007 and 2006. Nearly 90% of the growth in this product was driven by the Enterprise Edition, which we offer to financial advisors affiliated with larger firms. Advisor Workstation Office Edition for independent financial advisors contributed the remainder. Total licenses for Advisor Workstation in the United States increased by about 14% in 2007. Part of this growth reflects changes in the scope of some contracts. In 2007, a few clients who previously held tools-only contracts converted to full-site licenses when they renewed their contracts. For full-site licenses, we include all affiliated advisors who have access to the site in our total license count. By contrast, for tools-only contracts, we include a smaller number of advisors in the total based on actual usage.

 

Licensed Data was the third-largest contributor to organic revenue growth in 2007. This growth was driven by both new clients and higher contract values for existing clients. Including the impact of acquisitions, Licensed Data was also a major contributor to revenue growth, as product revenue now includes newly incorporated revenue from the fund data business acquired from Standard & Poor’s and Aspect Huntley’s institutional database.

 

Revenue from international operations continues to become a more important part of our business. Because the fund data business acquired from Standard & Poor’s has a strong presence in non-U.S. markets, this acquisition boosted our revenue outside the United States. Our non-U.S. revenue increased to 20.6% of consolidated revenue in 2007—6.6 percentage points higher than in 2006.

 

Revenue from international operations grew $45.4 million, or 102.5%, to $89.7 million in 2007. Approximately half of this revenue increase came from the fund data business acquired from Standard & Poor’s. Revenue from non-U.S. operations increased $14.9 million, or 50.4%, to $44.3 million in 2006. Our acquisitions of Aspect Huntley and Ibbotson contributed $8.3 million of the increase. In January 2008, we completed our acquisition of several Hemscott businesses from Ipreo Holdings LLC. Because most of Hemscott’s revenue is from markets outside the United States, we expect our non-U.S. business to continue increasing as a percentage of total revenue.

 

Foreign currency translations had a much smaller, but still favorable, impact on international revenue in both 2007 and 2006. Foreign currency translations contributed $3.8 million of the increase in non-U.S. revenue in 2007 and $0.8 million in 2006. Excluding acquisitions and the impact of foreign currency translations, our non-U.S. revenue increased 22.4% in 2007 and 19.6% in 2006.

 

The tables below present a reconciliation from international revenue to international revenue excluding acquisitions and the impact of foreign currency translations (international organic revenue):

 

2007 vs. 2006 ($000)

 

2007

 

2006

 

Change

 

International revenue

 

$

89,680

 

$

44,276

 

102.5%

 

Less: acquisitions

 

(31,690

)

 

NMF

 

Less: impact of foreign currency translations

 

(3,808

)

 

NMF

 

International revenue excluding acquisitions and the impact of foreign currency translations

 

$

54,182

 

$

44,276

 

22.4%

 

 

2006 vs. 2005 ($000)

 

2006

 

2005

 

Change

 

International revenue

 

$

44,276

 

$

29,442

 

50.4%

 

Less: acquisitions

 

(8,268

)

 

NMF

 

Less: impact of foreign currency translations

 

(793

)

 

NMF

 

International revenue excluding acquisitions and the impact of foreign currency translations

 

$

35,215

 

$

29,442

 

19.6%

 

 

GRAPHIC

 

48



 

Our five largest products based on revenue—Investment Consulting, Licensed Data, Morningstar Advisor Workstation, Morningstar.com, and Principia—made up about 60% of our consolidated revenue in each of the past three years. While the percentage of our revenue made up by our top five products has remained relatively consistent, the order of the products within the top five has changed each year. Investment Consulting became our largest product in 2006 and remained there in 2007. Because of organic growth as well as new revenue from Aspect Huntley and the mutual fund data business acquired from Standard & Poor’s, Licensed Data moved up to become our second-largest product in 2007.

 

Top Five Products (Segment) 2007

 

Revenue
($000)

 

% of Consolidated
Revenue

 

Investment Consulting (Institutional)

 

$

 75,595

 

17.4

%

Licensed Data (Institutional)

 

59,207

 

13.6

 

Advisor Workstation (Advisor)

 

54,980

 

12.6

 

Morningstar.com (Individual)

 

37,630

 

8.6

 

Principia (Advisor)

 

28,760

 

6.6

 

 

Top Five Products (Segment) 2006

 

Revenue
($000)

 

% of Consolidated
Revenue

 

Investment Consulting (Institutional)

 

$

 46,597

 

14.8

%

Advisor Workstation (Advisor)

 

43,140

 

13.7

 

Licensed Data (Institutional)

 

37,730

 

12.0

 

Morningstar.com (Individual)

 

31,311

 

9.9

 

Principia (Advisor)

 

28,735

 

9.1

 

 

Top Five Products (Segment) 2005

 

Revenue
($000)

 

% of Consolidated
Revenue

 

Licensed Data (Institutional)

 

$

 32,435

 

14.3

%

Advisor Workstation (Advisor)

 

29,280

 

12.9

 

Principia (Advisor)

 

28,788

 

12.7

 

Morningstar.com (Individual)

 

25,502

 

11.2

 

Investment Consulting (Institutional)

 

21,904

 

9.6